Costco stock analysis: evaluating the investment potential

Understanding Costco's business model

Costco Wholesale Corporation operates on a unique bulk-discount retail model that has proven highly effective over the years. Unlike many retailers, Costco's primary profit driver isn't product margins, but rather membership fees. This approach has allowed the company to offer competitive prices while maintaining a loyal customer base.

The company's recent decision to increase membership fees is likely to boost near-term profits. This move demonstrates Costco's confidence in its value proposition and customer loyalty. It's worth noting that historically, fee increases have had minimal impact on membership renewal rates.

Costco's model has shown resilience in various economic conditions, making it an attractive option for investors. The company's ability to adapt to changing consumer preferences and maintain its value-focused approach has been key to its success.

With room for domestic expansion and growing international success, Costco's fundamentals remain strong. The company continues to open new warehouses both in the US and abroad, tapping into new markets and demographics.

Analysing Costco's stock performance

Costco's stock price has seen an impressive surge of 40% this year, reaching new record highs this month. This remarkable performance has outpaced many of its retail competitors and the broader market indices.

However, this surge has led to some concerns about valuation ahead of its 26 September 2024 fourth-quarter (Q4) results. Costco shares now trade at a trailing price-to-earnings (P/E) ratio of 56, which is significantly higher than the retail sector average. For comparison, e-commerce giant Amazon, often considered a high-growth stock, trades at a P/E of 45.

This high valuation raises questions about whether Costco's current financials support such a premium. In the last nine months, the company reported revenue growth of 7% and net income growth of 17%. While these figures are solid, they may not justify the current valuation levels in the eyes of some investors.

It's important to note that high P/E ratios can sometimes be justified by strong growth prospects or other factors. However, potential investors should carefully consider whether Costco's future growth potential aligns with its current valuation.

Costco's unique dividend approach

One of Costco's most interesting features for income-focused investors is its unusual split dividend strategy. This approach consists of two components: a regular quarterly dividend and special dividends paid at irregular intervals.

The company's regular quarterly dividend currently stands at $1.16 annually. While this may seem modest compared to some other blue-chip stocks, it's the special dividends that make Costco's payout strategy unique.

Costco has a history of paying large special dividends when excess cash builds up on its balance sheet. The most recent special dividend, paid in January, amounted to $15.00 per share. This substantial payout demonstrates the company's commitment to returning value to shareholders.

Given Costco's pattern of paying special dividends and its latest $12.00 billion net cash position, investors can reasonably expect additional special payouts in future years. This prospect adds an element of potential upside for long-term shareholders.

Evaluating Costco's dividend sustainability

When assessing a company's dividend, it's crucial to look at its sustainability. Costco's regular dividend appears well-supported, with a low payout ratio of 26%. This indicates that the company is distributing only a quarter of its earnings as regular dividends, leaving ample room for future increases or additional special dividends.

The company's strong cash flow generation and robust balance sheet further support its dividend strategy. Costco's membership-based model provides a steady stream of revenue, which contributes to its ability to maintain and potentially grow its dividend over time.

However, investors should remember that special dividends, by nature, are not guaranteed. While Costco has a track record of paying these, future special dividends will depend on the company's financial performance, cash position, and strategic priorities.

Technical analysis on the Costco share price

The Costco share price is currently showing negative divergence on the daily chart, increasing the odds of this year's bullish spell perhaps giving way to a correction. But even then, provided the early August low at $793.00 underpins, the medium-term uptrend remains intact.

Costco share price daily candlestick chart

A rise above its mid-September all-time high at $923.83 would probably negate the negative divergence (unless it were to turn into a triple negative divergence) and lead to the Costco share price attacking the psychological $1000.00 mark.

Costco share price analyst ratings

According to London Stock Exchange Group (LSEG) Data & Analytics, analysts rate Costco as a ‘buy’ with 9 strong buy, 16 buy, and 12 hold.

TipRanks shows an analyst consensus of ‘strong buy’ with 17 buy and 5 hold and rates the Costco share price as a 9 out of 10 outperform.

Weighing the pros and cons of investing in Costco

Investing in Costco stock presents both opportunities and challenges. On the positive side, the company boasts a strong brand, a loyal customer base, and a proven business model. Its membership-based approach provides a steady revenue stream, and the company has demonstrated its ability to grow both domestically and internationally.

Costco's unique dividend strategy, combining regular payouts with occasional large special dividends, can be attractive for income-focused investors. The company's strong balance sheet and low payout ratio suggest that this approach could be sustainable in the long term.

However, the primary concern for potential investors is Costco's current valuation. The high P/E ratio suggests that much of the company's future growth potential may already be priced into the stock. This could limit potential upside in the short to medium term.

Additionally, while Costco has shown resilience in various economic conditions, it's not immune to broader retail sector challenges such as changing consumer preferences and increasing competition from e-commerce players.

How to invest in Costco stock

If you've decided to invest in Costco stock after careful consideration, here are the steps to follow:

1. Conduct thorough research on Costco, including its financials, growth prospects, and risks. Consider how it fits into your overall investment strategy and risk tolerance
2. Open a share dealing account with a reputable broker like IG. This will give you access to trade Costco shares and other global stocks
3. Once your account is set up, use the platform or app to search for Costco stock. The ticker symbol for Costco on the NASDAQ is COST
4. Decide how much you want to invest. Remember to consider your overall portfolio diversification and not to invest more than you can afford to lose
5. Place your trade by selecting the number of shares you wish to buy or the amount of money you want to invest.

Remember, you can also practise trading without risking real money by using a demo account. This can help you get familiar with the platform and the process of buying shares.

Conclusion: is Costco stock a buy?

While Costco's soaring valuation raises some yellow flags, the company's effective business model, membership fee increase, domestic and international growth potential, and unique split dividend approach help support a bullish long-term outlook.

Investors must carefully weigh the valuation risks against the likelihood of ongoing special dividends and regular dividend growth. Costco's strong fundamentals and proven business model make it an attractive option for long-term investors who believe in the company's continued success.

However, given the current high valuation, potential investors might want to consider waiting for a more attractive entry point or dollar-cost averaging their investment over time. As always, it's crucial to conduct your own research and consider seeking advice from a financial professional before making any investment decisions.

Remember, past performance doesn't guarantee future results, and all investments carry risk. Diversification across different sectors and asset classes remains a key principle of sound investing.