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Rupert Hargreaves
Rupert Hargreaves
Articles (1342)  | Author's Website |

A Look at Costco Through the Eyes of Charlie Munger and Warren Buffett

Why these two billionaires like the business and its current valuation

There's one stock that we know both Charlie Munger (Trades, Portfolio) and Warren Buffett (Trades, Portfolio) love. Apart from Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) and Wells Fargo (NYSE:WFC), there's one business they have both repeatedly praised for its growth and unique operating model: Costco Wholesale Corp. (NASDAQ:COST).

The favorite business

Buffett originally purchased 24 million shares in Costco for Berkshire's portfolio during the second quarter of 2000 after the stock fell 37% following the company's announcement of worse-than-expected earnings. Although the holding company has since reduced its position in the retailer, it still holds 4.33 million shares. Meanwhile, Munger sits on the company's board and owns the stock in his personal portfolio.

When asked what his favorite company was in an interview in 2011, he stated, "That's easy. It's Costco." The billionaire investor went on to add:

"It's one of the most admirable capitalistic institutions in the world. And its CEO, Jim Sinegal, is one of the most admirable retailers to ever live on this planet...I just can't say enough about my admiration for Costco. More of you should look at Costco. In fact, every time Donald Trump says something and you get discouraged, you should think about Costco."

Munger continued:

"It has a frantic desire to serve customers a little better every year. When other companies find ways to save money, they turn it into profit. Sinegal passes it on to customers. It's almost a religious duty. He's sacrificing short-term profits for long-term success."

It could be argued that this retailer falls into Buffett's bucket of "inevitables." These companies produce steady, predictable profits, no matter what the environment, and continue to improve year after year.

An inevitable income stream should make a business easier to value. If you can estimate a company's cash flows with a high degree of certainty many years out, it's easier to place a value on those cash flows and use an appropriate discount rate.

With that in mind, I thought I'd try my hand at estimating the intrinsic value of Costco using Buffett's method of cash flow analysis. Keep in mind, this is only my estimation of Buffett's method based on my studies of the Oracle of Omaha - Buffett himself has never provided such a step-by-step valuation formula.

A look at Costco

We can make a relatively safe assumption that Costco's free cash flow will grow by at least the inflation rate every year. The company has the ability to raise prices in line with inflation and still keep its customers. Costco's competitive advantage lies in its size and being able to sell more with less. That's not going to change unless the business undergoes a fundamental shift in management.

On that basis, if other retailers are all increasing their prices in line with inflation, Costco should be able to do the same and maintain its cost advantage.

Over the past 25 years, food prices have increased at an average annual rate of 2.3% in the United States. This is the growth rate I will be using for the company's free cash flow in perpetuity.

In its last financial year, Costco produced just under $5 billion of free cash flow. In previous articles, I've highlighted Buffett's earlier comments about discount rates in which he's said he would add around 3% to the risk-free rate.

At the time of writing, the risk-free rate on the 10-year Treasury is just under 0.9%. Adding 3% gives a rate of 3.9%. For a margin of safety, I'll round up to 4%.

Based on these figures, a discount cash flow forecast suggests the stock could be worth as much as $681 per share as compared to the Oct. 23 price of around $374.94.

Keep in mind, these are only rough estimates and are not designed to be an accurate valuation. Nevertheless, in my view, they show how undervalued this predictable retailer is in the current interest rate environment.

Disclosure: The author owns shares in Berkshire Hathaway and Wells Fargo.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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