Costco Stock: A Cautionary Tale of History Repeating Itself?

Costco Wholesale (NASDAQ: COST) has long been a darling of investors, offering a compelling combination of low prices, high-quality products, and a loyal membership base. However, as the stock price continues to soar, reaching record highs and a nosebleed P/E ratio of over 54, investors may want to take a closer look at the lessons from the past.



In 1999, Costco's stock price fell more than 20% in a matter of months after its trailing 12-month P/E multiple hit 56.4. This decline can be attributed to a few factors:

1. Dot-com bubble burst: Costco's stock was caught up in the exuberance and the inevitable aftermath of the dot-com bubble. Many stocks sported valuations that weren't justified by their business fundamentals, and Costco was no exception.
2. Market exuberance: The stock market was expensive in 1999, with enthusiasm about artificial intelligence (AI) being a key driver behind the boom. This led to premium valuations for many stocks, including Costco.
3. High P/E ratio: Costco's high P/E ratio in 1999 indicated that the stock was overvalued compared to its earnings. This made it vulnerable to a correction when investors became more risk-averse.

Today, there are some potentially worrisome similarities between 1999 and 2025:

* The stock market is again expensive, with premium valuations not limited to AI stocks.
* Costco's P/E ratio is still at a nosebleed level, with a forward earnings multiple of 50.8 and a PEG ratio of 5.5.
* The market is in an AI bubble reminiscent of the dot-com bubble, with some observers believing that the market is in an AI bubble.

These factors suggest that history could repeat itself, and Costco's stock price could tumble if the market corrects or investors become more risk-averse. However, it's important to note that a sample size of one is useless in predicting what might happen, and the current situation may not play out the same way as it did in 1999.



The case for buying Costco stock

Several of my Motley Fool colleagues believe that Costco's shares can continue to rise despite its high valuation. And they make a solid case for buying the stock. Demitri Kalogeropoulos recently wrote, "Costco has earned its premium over peers by putting together a long streak of market-beating performance, driven by its focus on offering high-quality products at low prices and maintaining a strong membership base."

Moreover, Costco's earnings growth trajectory has significantly improved since 1999. In 1999, when the company's P/E ratio reached 56.4, its earnings growth was relatively low. However, since then, Costco has consistently delivered strong earnings growth. For instance, in its latest quarter, the company reported year-over-year earnings growth of 13%.

This improvement in earnings growth has had a positive impact on Costco's valuation. Despite its high P/E ratio of over 50, the company's stock price has continued to perform well. This is because investors are willing to pay a premium for companies with strong earnings growth prospects.

However, if Costco's earnings growth slows down significantly, its share price is likely to fall to a level more in line with realistic growth expectations. Therefore, it's crucial for investors to monitor the company's earnings growth trajectory and assess whether its current valuation is justified by its earnings growth prospects.



Inflation and Costco's business model

Inflation can have both positive and negative effects on Costco's business model and its stock price. Here's how:

1. Positive effects of inflation on Costco:
- Increased demand for discount goods: Inflation often leads to higher prices for goods and services, which can drive consumers to seek out cheaper alternatives. Costco's business model, which offers a wide range of products at discounted prices, can benefit from this increased demand.
- Higher membership fees: Costco generates revenue from both store sales and membership fees. If inflation leads to higher prices for goods and services, consumers may be more likely to join or renew their Costco memberships to save money.
- Potential for higher profit margins: While Costco's profit margins are typically lower than those of other retailers, the company has shown the ability to maintain or even increase its margins during periods of inflation. For example, in its fiscal 2022 annual report, Costco reported a gross margin of 14.4%, up from 14.2% in the previous year, despite higher input costs due to inflation.

2. Negative effects of inflation on Costco:
- Reduced consumer spending: High inflation rates can lead to reduced consumer spending, as people have less disposable income to allocate towards discretionary purchases. This could potentially hurt Costco's sales, as consumers may cut back on non-essential items.
- Potential supply chain disruptions: Inflation can cause supply chain disruptions, leading to shortages or increased costs for certain products. This could impact Costco's ability to maintain its inventory and offer a wide range of products at discounted prices.
- Potential impact on stock price: If inflation leads to a significant slowdown in consumer spending or supply chain disruptions, it could negatively impact Costco's stock price. However, as seen in the past, Costco has shown resilience during economic downturns, and its stock price has generally recovered once the economy improves.

In conclusion, while inflation can have both positive and negative effects on Costco's business model, the company's focus on offering discounted goods and its strong membership base make it well-positioned to weather economic storms. However, the ultimate impact on Costco's stock price will depend on various factors, including the severity and duration of inflation, consumer spending habits, and the broader economic landscape.



Investment advice

Given the high valuation and potential risks, investors should exercise caution when considering Costco stock. While the company has a strong track record and a compelling business model, its high P/E ratio and the potential for a market correction make it a risky investment at this time. Investors should consider taking profits on Costco stock and reallocating those funds to other, more attractively valued opportunities in the market.

Moreover, investors should monitor Costco's earnings growth trajectory and assess whether its current valuation is justified by its earnings growth prospects. If earnings growth slows down significantly, investors may want to reconsider their position in Costco stock.

In conclusion, while Costco has a strong track record and a compelling business model, its high P/E ratio and the potential for a market correction make it a risky investment at this time. Investors should exercise caution and consider taking profits on Costco stock to reallocate those funds to more attractively valued opportunities in the market.