Wal-Mart or Costco: A Comparison in Retail Giants

Wal-Mart or Costco A Comparison in Retail Giants

One is currently out of fashion and the other is a golden boy. One is supposedly facing doom from the rise of Amazon and the other supposedly doesn’t face this threat. One trades at 11.6 price to earnings while the other trades at 30 price to earnings. One gives you 2.58 times more earnings off the bat while the other, well, gives you 2.58 times less earnings off the bat. Wal-Mart vs. Costco: which is the better asset to buy?


 
A friend and I were discussing Costco last night and it piqued enough interest in me to break out a few notes to do a rough, back-of-the-envelope comparison between the two retail giants. My friend likes Costco, but is the current price – $161 a share as of close on December 1, 2015 – rational to buy into the asset? Is the seemingly lofty 30 P/E ratio that is currently attached to Costco worthy or is it an indication of slight over-valuation and risk of P/E compression going into the future?

Financial Ratios

To get a sense of the two companies, I drew up a quick spreadsheet with the following information:

  • Hypothetical $1000 investment
  • P/E Ratio
  • Earnings Yield
  • Net Profit Margin
  • Asset Turnover
  • Equity Multiplier
  • Return on Assets
  • Return on Equity
  • Return on Capital Employed
  • Return on Invested Capital
  • 5 Year Analyst Earnings Growth Estimate (averaged down to the nearest whole percentage)
  • Current Earnings per Share
  • Total Earnings based on a Hypothetical $1000 investment

I’ve thrown in Kroger to compare with Wal-Mart and Costco just to have another retail/grocery giant as a reference point. In case you need to brush up on some of the ratios, there is a legend attached at the end of this post. Here is the spreadsheet:

A Comparison in Retail Giants - Wal-Mart or Costco

Wal-Mart vs. Costco

On first glance over these ratios, you notice that Wal-Mart has the largest net profit margin at 3.4%. However, Costco is more efficient at using its assets to generate revenue. Costco also employs more leverage, resulting in a higher Return on Equity ratio. Costco also generates higher Return on Capital Employed. Wal-Mart and Costco share an almost identical Return on Invested Capital figure. Analysts believe Costco will grow earnings much higher over the next 5 years than Wal-Mart.

Also, not shown in the table above is the dividend yield for both companies: Wal-Mart gives you a starting yield of 3.3% while Costco gives you a 1% starting yield.

It should be obvious that the market is more optimistic about Costco’s prospects as an investment. However, is a P/E ratio of 30 justified? Is it a fair deal?

Growth Rate

Based on the ratios above, I don’t see much variance in the financial ratios of either company. Therefore, we can then assume that the P/E is almost 2.6 times higher for Costco because of its higher expected earnings growth rate into the future.

There are two old school, super conservative, back of the envelope ways to gauge whether Costco is an ideal buy candidate at this price point, these earnings, and the expected growth rate of 8%.

Graham & Lynch

We could use something Benjamin Graham once recommended, which was that you should never buy a stock that had a P/E ratio that was higher than the sum of the earnings yield and the growth rate. By this definition, 30 P/E is much higher than 11.33 (the sum of 3.33% earnings yield and 8% assumed earning growth rate). For Wal-Mart, the gap is a little closer at 11.64 P/E vs. 9.59 (the sum of 8.59% earnings yield and 1% assumed growth rate).

Instead of Graham’s method, we could try Peter Lynch’s famous Price-Earnings-to-Growth ratio, adjusting for the dividend yield of each company. When it came to the PEG ratio, Lynch advocated for anything that came up below 1. This indicated a likely, screaming value.

Costco turns up a dividend-adjusted PEG ratio of 3.3 (30.05/(8+1)). Wal-Mart gives a PEG ratio of 2.7 (11.64/(1+3.3)).

Well, it appears, neither meets the strict standards of either Benjamin Graham or Peter Lynch – where to from here?

Undervalued? Overvalued? Fair Value?

So we don’t appear any closer to figuring out whether Costco is a good deal at current prices. Since I did say that this was more of a quick, back-of-the-envelope type of exercise – my favorite kind of exercise when it comes to security analysis as I think there is some danger with trying to get too precise with financial figures – here’s my conclusion.

Costco is a great enterprise. Anyone who has shopped at Costco could tell you that it is a fantastic business. This is entirely anecdotal, but I imagine it applies to almost all Costco’s out there: whenever I’ve been in a Costco, it is insane how many people are there buying stuff. It doesn’t take a genius to see it is a great business.

With that said, at a market capitalization of $71.6 billion, Costco is no upstart, spring chicken. Yes, it still has room to expand stores, revenue, and profit, but it’s most likely well past it’s explosive growth days.

Buying ownership at current prices will potentially lead to satisfactory results, based on several assumptions. If the analyst predictions are correct on the 8% earnings growth over the next 5 years, earnings per share should grow to $7.89 by 2020. If the market is still willing to pay 30 price earnings in 2020, the stock price should be $236. That means the price of the share appreciated from $161 today to $236 by 2020. Add in the 1% dividend yield you get to collect along the way, and based on all of these conditions and assumptions, you could potentially expect 9% compound annual growth over the next 5 years.

Of course, these are based on the conditions listed above. There could be a contraction in the price earnings ratio that investors are willing to pay in the future, which would have a detrimental effect on the returns you experience. Alternatively, perhaps investors will clamor to pay in excess of 30 price earnings, in which case your growth rate over the 5 years will increase. Perhaps we hit a recession and a market crash? Or perhaps the bull market continues? The future is highly uncertain.

Conclusion

In conclusion, be wary of crystal balls and attempt to peer into the future with any precision. It is very difficult, if not impossible, to predict with any certainty where the valuation of an asset will be years down the road.

In this scenario, I advise you do take Benjamin Graham’s advice regarding the “fat man test.” Graham noted that you do not need to know the exact weight of a man to know whether he is fat or not. In the same vein, you do not need to know with precision (because you probably can’t) whether or not an asset is a good deal or not, as it should yell at you that it is either extremely cheap or extremely expensive.

To give you an example, it is my opinion that Facebook at its current price and earnings passes the fat man test as extremely expensive. I do not need to know the precise details and projections of Facebook’s financials to come to that conclusion.

So using the concept of the fat man test, I would conclude that Costco, based on the analyst expectations and current price, is slightly over-priced to fair value. Based on the numbers currently available and the aggregate of analysts’ opinion, one should expect satisfactory results even at the seemingly high price earnings ratio, but not over-performance of the market at large.

In my opinion, I find Wal-Mart much more tantalizing in terms of the fat man test as the expectations are so low right now for the company that even a mild out performance over the next several years should potentially see the price earnings ratio expand back into the mid-teens where Wal-Mart typically hangs out. Along with collecting a 3.3% starting dividend yield, for me, there exists a bit more of a margin of safety built into Wal-Mart at these current prices for potential ownership.

 


 

Legend

Price/Earnings = Stock Price / Earnings per Share

Earnings Yield = Earnings per Share / Stock Price

Net Profit Margin = Net Income / Revenue

Asset Turnover = Revenue / Total Assets

Equity Multiplier = Total Assets / Shareholder’s Equity

Return on Assets = Net Profit Margin x Asset Turnover

Return on Equity = Net Profit Margin x Asset Turnover Equity Multiplier

Return on Capital Employed = Earnings before Interest & Tax / (Total Assets – Current Liabilities)

Return on Invested Capital = (Net Income – Dividends) / Total Capital

Dividend Adjusted Price-Earnings-to-Growth = (Stock Price / Earnings per Share) / (Assumed Growth Rate + Dividend Yield)

 


 

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  • I like the fat man test. 😀

    Love the fact that you broke down the analysis during a conversation with a friend. Totally awesome. I’d love to own Costco but at current evaluation I think it’s too expensive. It’s also hard to evaluate future growth for Costco.

    • In my opinion (for what it’s worth), I wouldn’t mind buying ownership in Costco at a lower earnings multiple. I just don’t see how the P/E ratio can expand much further based on business fundamentals. I see the danger of P/E contraction more likely than expansion – ie. I think it’s more likely people will pay a lower multiple to earnings in the future than higher. I mean, we could experience something akin to the Dot Com bubble where people paid insane multiples on earnings, but that’s not an environment I want to be buying assets in.

  • Mr. 1500

    Costco is one I do own. I bought 50 shares on 8/16/2012 for $96.43. So far, it has worked out well. However, I cannot deny the pricey valuation either.

    Counting on growth is a risky proposition, but one that I have accepted in the past; I bought Google and facebook at IPO and Tesla back in 2012 in the 20s. Google has grown into its shoes many times over. You already pointed out facebook has a ridiculous valuation. Google had a ridiculous valuation at one time as well. Of course, Tesla has the biggest shoes to fill of all. While I’ve been right more than I’ve been wrong, I fully acknowledge that these were extremely speculative and dangerous moves.

    I’m not sure what to think. What you say is rational, sound and correct. Most of the stocks I own, I’d never buy at their current valuation. For the most part, these stock purchases are a relic to a different me. Then, I catch myself looking at SoFi and drooling at it’s disruption potential. Ha!

    Really though, I’ve bought one stock in the past 3 years (Lending Club) and it was only $10,000. All new money goes into index funds.

    Except for maybe that upcoming SoFi IPO…

    • In 2012, Costco had a P/E ratio of 24.8 based on diluted normalized EPS of 3.89 in 2012. You got to experience a nice P/E expansion from ~25 to 30, leading to a CAGR of ~20% with the dividends collected along the way. I’d be much more interested in Costco at 25 P/E vs. 30 P/E – to generalize, there is much more risk in a P/E contraction into the future as opposed to further P/E expansion.

      I can honestly see how even I could rationalize Facebook at P/E 100+ based on the earnings growth projections and all the potentially lucrative projects they are working on. It’s so seductively easy to buy into the hype – and the hype might turn into reality. I think it’s just as likely that Facebook is justified at P/E 100 as it isn’t. However, everything I have learned says that discipline is extremely important. If one is going to conduct security analysis, you need a framework to work off – in this case I find value investing in a general sense to be the most sane option – and you have to be ok with discarding almost every potential investment that comes across the desk.

      With the framework of value investing in mind, I’m ok with passing on Tesla, Facebook, Twitter, and whatever other exciting growth stock that has potentially explosive earnings growth attached to it. If it does not have any history of earnings, I have no idea how I am suppose to approach it as a rational and logical investment. Therefore, it is discarded and I have no regrets if in the future if these companies end up being 10+ baggers. I’ve taken the advise of 1) circle of competence; 2) value investing fundamental principles; and 3) never lose money deadly seriously. For me personally, it’s all about the best risk-adjusted return.

      Oh, I would love to speculate in the Teslas and Facebooks. But that has to be compartmentalized into a totally separate, removed account that is fully acknowledged as Pure Speculation/Gambling that is totally different from investing.

      And on the other hand, I think to myself that I could just buy VT consistently every month and not think about any of this. I suppose if one does not find security analysis at least interesting and entertaining, low-fee-total-market-index-funds are the most logical approach.

      Haha and don’t get me started on the SoFi IPO. I’m reminded of the words of Graham: “Most new issues are sold under favorable market conditions, which means favorable for the seller and less favorable for the buyer.”

      • Even something like Amazon, which is a business I use and appreciate highly, I have no idea how to logically value the business as there are little to no earnings. I mean, I understand the premise that earnings are reinvested back into the business and that the promise is that earnings for owners will come in the future, but that’s just too speculative for me and I have no idea how Amazon is a sound investment option based on what I currently know and can understand. Therefore, it’s outside my circle of competence and I discard it and move on to something I can actually understand.

        • Stephen H

          I think, if I were going to get a retail position, it might be worth doing like 3/4 in something like WMT or COST and then other quarter position in Amazon. I know the point of investing isn’t fun, but it sometimes can be to have a black sheep like Amazon in your portfolio as a small holding to watch. After all, you really don’t know what they will be doing in the future!

          • After thinking about this more for a year, while Wal-Mart is the “better” company in terms of current EPS per $1,000 dollars invested, without taking valuation into account, I think Costco and Amazon are the better retail businesses currently and going into the future.

            My fear is that Wal-Mart is, ironically, the Sears Roebuck of today and Amazon is the Wal-Mart of the past, about to eat it alive in the coming years/decades.

            I think Wal-Mart at lower prices present attractive short-to-mid-term trading opportunities but I don’t have lots of confidence in it as a long term, buy and forget holding.

      • Mr. 1500

        You are logical and rational. Like I said, all new money is going into the index funds, so I’m not as crazy as you think. When I sell the stocks (I do it every January), if I have a satisfactory cash pile, the money will be invested in index funds.

        Do you consider Munger to be a value investor? I was highly amused that old, “I hate technology man” invested in BYD.

        • Whenever it does not becoming interesting and fun to read annual reports and look into companies, that will be the day I convert everything to index funds.

          I think the other reason may be if I am lagging the S&P 500 badly in 5 years time. If by 2021 my returns are horrifically trailing the index, I will call it a day and adjust 90% of the equity assets into a total market fund like VT and forget about it. Go take up sky diving or something as an alternative hobby.

          I consider Munger an extreme varient of value investor that most people do not have the skills, patience, or temperament to imitate. I don’t think I even do. This is the man that sat on cash for years on end and then bought an insane amount of Wells Fargo and Bank of America during the market crash of 2008. I don’t know if I have the cahoots to do something like that. Maybe nibble at a basket of banks, but not going all in on 2 of them in the depths of a financial crisis.

          Anyways, umm I don’t know too much about the BYD saga. I don’t even really know much about BYD. I dunno, sounds kinda like a Chinese Tesla? I mean, knowing nothing about the company, I can see the appeal that as one of the largest rechargeable battery makers in the world, there is potential. But I honestly don’t really know anything about it. I mean I suppose it isn’t tech in the sense of Facebook and Twitter kind of tech?