Costco stock is trading at more than 50 times earnings for the second time in its history. What happened last time may be an indication of what to expect this time.
Imagine if you could buy a company that makes $100,000 in annual profits for $1 million. In investment jargon, you’d say this company trades at ten times its earnings, or a price-to-earnings (P/E) ratio of 10. It’s useful. In this specific scenario, the purchase price would be recouped after 10 years. In year 11 and beyond, the investor could make serious money.
Of course, it’s too simplistic a way of looking at things. In the real world, income is rarely static. But it still shows how a price-to-earnings ratio works and why, if at all possible, you would want to buy a company at a lower price-to-earnings ratio.
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Buy shares of Costco Wholesale(NASDAQ: COST) with a lower price/earnings ratio not possible at this time. At the time of writing, Costco stock is trading at 55 times its earnings, marking only the second time in its history that its price-to-earnings ratio has exceeded 50.
COST PE ratio data per YCharts
Costco stock is up about 60% in the past year, crushing its price S&P500 and therefore attracts a lot of attention from investors. But should investors buy when the price/earnings ratio is so high? Well, investors can use history to guide that decision.
In early 1999, Costco’s shares rose more than 50 times their earnings. The famous dotcom bubble on the stock market was in full force at the time. Costco stock would reach an all-time high (at the time) in early 2000, just as the stock market bubble was about to burst. Eventually it popped and Costco stock lost about 50% of its value by the end of 2002.
Keep in mind that Costco’s business continued to perform quite well during this period. From early 2000 to late 2002, both sales and earnings per share (EPS) increased. But the share was still halved.
You might say it’s irrelevant to note that Costco’s price-to-earnings ratio was over 50 at the time. After all, when a bubble bursts, almost all stocks go down, regardless of valuation. But you could also argue that Costco’s lofty valuation was immediate result of the bubble, making it very relevant indeed.
It is possible that the S&P500 is currently back in bubble territory. From a price-to-earnings ratio perspective, the S&P 500 is currently trading at its second-highest valuation since the dot-com bubble burst over two decades ago. The only other time it was more expensive was in 2021, just before it plummeted in 2022.
In other words, Costco’s price-to-earnings ratio is back above 50 and an overvalued market could be the culprit, just like it was in 2000. And then Costco shares fell more than 50%.
A high price-earnings ratio is usually only appropriate if a company can achieve above-average earnings growth. But at Costco’s current size, I think earnings growth will be somewhat modest. For this reason, I wouldn’t be surprised if stocks fall in the near future as they have over the past two decades. In short, I can safely say that it is overvalued today.
But there is more to the story. It’s true that Costco stock fell, which was tragic for any investor who invested all their money at the top. But the company has a great business model and it ultimately rose again and has been an extraordinary long-term investment, returning more than 1,900% since 2000.
In other words, Costco stock was a great stock-dollar-cost average until its price-to-earnings ratio went above 50. Consider the potential returns from the table below.
If someone invested all their money in Costco stock at the valuation peak, it would take a while to recover. And a 10-year return of 58% wasn’t great. But by continuing to invest in a top company like Costco over time, investors could significantly improve their long-term returns while avoiding falling victim to a stock market crash. That’s a powerful thought.
I believe Costco stock is overvalued today and I would avoid making a substantial investment in the company at this time. That said, I also believe Costco is one of the best and most resilient companies out there, meaning this is a stock worth holding in a portfolio.
For those who agree with me about the quality of Costco’s business, I think it could be a good idea to spread out an investment over the next few years. This will help you avoid the risk of buying overvalued stocks before the market potentially falls.
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Jon Quast has no position in any of the stocks mentioned. The Motley Fool holds positions in and recommends Costco Wholesale. The Motley Fool has a disclosure policy.
Costco stock is trading at more than 50 times earnings for the second time in its history. What happened last time may be an indication of what to expect this time. was originally published by The Motley Fool
