It's been a strong day for Costco Wholesale Corporation. Its shares are now trading at $479.8, marking a 6.6% change since the previous market close. An analyst favorite, the Discount Store company has a rating of buy. But could the market and the analyst community be overvaluing this stock?
The most common valuation metric for stocks is the trailing price to earnings (P/E) ratio. Costco Wholesale has a P/E ratio of 49.1 based on its 12 month trailing earnings per share of $9.78. Considering its future earnings estimates of $10.99 per share, the stock's forward P/E ratio is 43.7. In comparison, the average P/E ratio of the Consumer Defensive sector is 24.21 and the average P/E ratio of the S&P 500 is 15.97.
Costco Wholesale's P/E ratio tells us how much investors are willing to pay for each dollar of the company's earnings. The problem with this metric is that it doesn't take into account the expected growth in earnings of the stock. Sometimes elevated P/E ratios can be justified by equally elevated growth expectations.
We can solve this inconsistency by dividing the company's trailing P/E ratio by its five year earnings growth estimate, which in this case gives us a 2.46 Price to Earnings Growth (PEG) ratio. Since the PEG ratio is greater than 1, the company's lofty valuation is not justified by its growth levels.
We can also compare the ratio of Costco Wholesale's market price to its book value, which gives us the price to book, or P/B ratio. A company's book value refers to its present liquidation value -- or what would be left if the company sold off all its assets and paid off all of its debts today. Importantly, the book value does not include intangible assets such as the value of its brand and the goodwill of its customers. COST has a P/B ratio of 13.6, with any figure close to or below one indicating a potentially undervalued company.
A comparison of the share price versus company earnings and book value should be balanced by an analysis of the company's ability to pay its liabilities. One popular metric is the Quick Ratio, or Acid Test, which is the company's current assets minus its inventory and prepaid expenses divided by its current liabilities. Costco Wholesale's quick ratio is 0.415. Generally speaking, a quick ratio above 1 signifies that the company is able to meet its liabilities.
The final element of our analysis will touch on Costco Wholesale's ability to generate cash for the benefit of its shareholders or for reinvesting in the business. For this, we look at the company's levered free cash flow, which is the sum of all incoming and outgoing cash flows, including the servicing of current debt and liabilities. Costco Wholesale has a free cash flow of $3,501,000,000, which it uses to pay its shareholders a 0.6% dividend.
With most indicators pointing at a higher than average valuation with uncertain growth prospects, most analysts are either wrong about Costco Wholesale, or their research has uncovered one or more qualitative reasons to invest in the stock. For example, the strength of the management team and their plan for executing the business strategy may have convinced some analysts to give less weight to traditional quantitative factors.