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The recent membership price increase is bullish for profits in the near term.
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Warren Buffett said it was "probably a mistake" for his company to sell Costco stock in 2020.
The stock of Costco Wholesale (COST) continues to appear unstoppable. It has risen by more than 35% this year. Given the strength of its business and a recent membership price increase, the optimism surrounding this stock appears elevated.
However, this situation leaves new investors wondering what to do. Are the continued increases a sign that the retail stock's valuation doesn't matter, or are investors who buy now setting themselves up for months or years of pain if the sentiment suddenly turns negative?
The state of Costco
Costco shares have risen over the years as it developed one of the most ingenious retail models. The company stocks its warehouses with high-quality products typically sold in bulk for little more than the cost of goods sold plus overhead.
The company earns most of its profits from annual membership fees. Since its Gold Star membership in the U.S. just increased from $60 to $65 per year, profits will likely benefit from a one-time bump.
Moreover, Costco continues to add warehouses across the U.S. Even in its native U.S. market, the company still has plenty of room to expand to mid-size markets, and many major metros still lack a Costco Business Center, which tailors its product lines specifically to the needs of businesses.
Costco also has warehouses abroad. Since its model has succeeded in 14 different countries on four continents, it has sidestepped the cultural differences that hampered the growth of other international retailers such as Walmart.
Investing in Costco
Unfortunately for investors, the one Costco item that is not a bargain is its stock. It sells at a trailing P/E ratio of 56, a multiyear high for this stock. It is also higher than the longtime valuation leader among major retailers, Amazon, which now sells for 45 times earnings.
COST PE Ratio data by YCharts
Despite the recent price hike in memberships, the financials do not seem to justify its current P/E ratio. In the first nine months of fiscal 2024 (ended May 12), revenue of $175 billion was a 7% increase compared with the same period in fiscal 2023.
Costco kept its operating expense growth at 6%, enough that the $5 billion in net income for the first nine months of fiscal 2024 rose 17% yearly.
Moreover, it is not only average investors that have struggled with the valuation of Costco. Warren Buffett's team at Berkshire Hathaway sold its entire Costco position in the second quarter of 2020.
Berkshire held Costco stock for more than 20 years, and it was a favorite stock of Buffett and his late partner Charlie Munger. He likely believed other stocks would be better investments at that time. However, Buffett now describes the sale as "probably a mistake" as Costco is up nearly 200% since that time.
Valuation fears have undoubtedly led to missed gains for more conservative investors. Nonetheless, this history might remind investors to keep looking forward.
Should investors buy Costco stock now?
Despite the pain from missing out, investors should continue to treat Costco stock as a hold.
A hold call is a bitter pill to swallow for investors who passed on Costco for valuation reasons when it was cheaper than it is today. That feeling may push investors into paying the current price.
Still, acting on such feelings can also lead to losses if the sentiment turns, and investors should resist the temptation to overpay. This does not mean investors should expect a business like Costco to fall to a low P/E ratio. But ultimately, investors buy stocks like Costco in hopes of beating the market averages. Earning market-beating returns usually means they still need to demand a fair price (or below) for high-quality stocks, including ones named Costco Wholesale.
