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Costco’s Predictability Justifies Its Higher P/E

April 25, 2014 | About:
Chris Mydlo

Chris Mydlo

23 followers

The stock market has had quite a run in the past five years, and there has been an increase in volatility lately. Given these concerns, I ran a screen for highly predictable, defensive stocks in the retail industry using the screener at GuruFocus. There were only a few results and Costco Wholesale Corporation (COST) was at the top of the list. At first glance, Costco looks expensive given its P/E of 25.80. I think that its high predictability and low volatility decreases the cost of equity for Costco and justifies its high P/E ratio.

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Costco has our highest rating of five stars for business predictability based on a proprietary formula developed by GuruFocus. For the past ten years, the average annual gain for five star stocks has been 12.1 percent and only three percent of the stocks were at a loss if held for ten years. A stock with a high predictability rating has not had an operating loss in the past ten years. Although past performance is not the perfect indicator of future performance, with the right information we can obtain a better understanding of the general direction.

Our “Top 25 Undervalued Predictable Companies” portfolio has outperformed the S&P 500 by 30.08 percent since inception in 2009. You can see the portfolio here: “Top 25 Undervalued Predictable Companies

Costco’s low volatility keeps its intrinsic value high based on the capital asset pricing model (CAPM). Yahoo Finance lists the beta as 0.46, Google Finance lists it as 0.55, and GuruFocus lists it as 0.45. I will use the average of 0.487. For the calculation, I am using a market risk premium of 8 percent and a risk free rate of 2.7 percent, the 10-year US treasury rate.

Expected Return = Risk Free Rate + (Beta x Market Risk Premium)

Expected Return = 2.7 + (0.487 x 8) = 6.60 percent

6.6 percent is the expected return of Costco given its volatility compared to the S&P 500. The expected return is also considered to be the cost of equity and can be used to discount the company’s cash flows when determining its intrinsic value.

We can take a look at a few different factors for their growth; dividends, same store sales comparables (comps) and new store openings, and return on equity. Costco has been consistently raising its dividends over the past 10 years. The median percentage increase of their dividends has been 13.6 percent. The same number can also be achieved by taking the average dividend increase of the past 10 years while removing the high and low percentage increases. I removed the high and low numbers to eliminate any extremes in order to get a more accurate picture of the growth.

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Another method for growth is to calculate how fast the company is growing based on comps and new store openings. The comps from 2012 to 2013 increased at a rate of about 6 percent. Costco is planning on opening 30 new stores in 2014. 30 new stores will increase the number of stores by about 4.6 percent. Multiplying comps by the percentage growth of new stores results in overall growth of about 10.9 percent.

The last method is the simplest. Growth can be estimated by multiplying the return on equity by the company’s retention rate, or 1 – payout ratio. The return on equity for the trailing twelve months is 16.08 percent and the retention rate is 75 percent. The product of the two leads to a growth rate of 12.1 percent. All three of the growth figures are fairly close. I will use the lower of the three in my calculations to be more conservative.

Determining the intrinsic value of Costco can be done by plugging in the new figures into the DCF Calculator at GuruFocus. I adjusted the growth rate to be 10.9 percent and the discount rate to be 6.6 percent. Using these figures, I obtained a fair value of $118.10. The stock closed at $115.01 on 4/25/2014.

Conclusion

Although Costco has a high P/E of 25.8, it is still fairly valued. It is interesting to see how today’s low interest rates increase the market risk premium, thereby increasing the P/E multiple of stocks with lower volatility using CAPM. Let’s take a look at the effects on discount rates with different interest rates and betas:

10-yr Treasury

Beta

Mkt Risk Prem.

Discount Rate

2.7

0.5

8

6.7

2.7

1

8

10.7

2.7

2

8

18.7

10-yr Treasury

Beta

Mkt Risk Prem.

Discount Rate

3.7

0.5

7

7.2

3.7

1

7

10.7

3.7

2

7

17.7

10-yr Treasury

Beta

Mkt Risk Prem.

Discount Rate

4.7

0.5

6

7.7

4.7

1

6

10.7

4.7

2

6

16.7

In the low interest rate environment that we are in now, lower beta stocks will have a lower discount rate than in normal periods, thereby increasing its P/E multiple. In the same environment, high beta stocks should have a lower P/E than in a normal period. The opposite is true for periods of higher interest rates.

CAPM is one way to value securities. One of the drawbacks to CAPM is that it is deciding inputs for risk-free rates and market premiums. It seems that there are many opinions on which numbers to use. I used the 10-year treasury rate as the risk-free rate and 10.7 percent as the expected return of the market based on historical data and academic research.


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