Costco Wholesale (COST) has been one of the stock market’s biggest success stories. Over the past five years, its stock has surged nearly 240%, including a 50% gain in the last year alone. Investors are enamored with Costco’s predictable business model, which is built on membership-driven recurring revenue, cost efficiency, and impressive customer loyalty rate. While the company operates in a competitive market, Costco possesses a commanding industry position (over 60% market share of the US warehouse club market according to Statista), and a unique value proposition that supports its consistent cash flow and growth.
As a shareholder, I value these qualities, but at its current valuation, is the stock too expensive?
Similar to my previous article on Netflix, Costco is another high-quality name trading at levels that are difficult to justify. With a P/E multiple at over 50x forward earnings, the retailer is trading well above pre-pandemic levels when its multiple was closer to 30x. Costco’s EV/EBITDA multiple is over 30x, significantly higher than peers like Walmart, Target and Amazon. This premium comes despite Costco’s expected revenue growth in the mid-single digits and free cash flow growth in the high single digits.
At these levels, Costco’s stock is pricing in decades of growth, and has become disconnected from reasonable expectations.
In this article, I will explore the factors driving the optimism in Costco’s stock, and why its stock price appears to be out of touch with reality. This will be grounded in a discussion of my valuation assumptions to determine a fair price for Costco.
Why the Market Loves Costco Right Now
To put it simply, the optimism surrounding Costco stems from the growing belief that it is a near-riskless investment. This is as opposed to believing the company is going to grow by leaps and bounds. The perception driving the stock is that Costco’s business is uniquely resilient, capable of not just surviving any economic environment, but also thriving. Investors see it as a business with near-guaranteed stability and predictability which is supported by loyal customers, consistent revenue streams, and a pricing model that keeps shoppers coming back.
There is some truth to this. Costco has built a durable business model that has established itself as a near-irreplaceable necessity for consumers. Consumers see the retailer as a way to cut costs on essential goods because of the lower prices (relative to competitors) their able offer.
To truly understand the market’s perspective, we need to explore what makes Costco such a dominant force in its market. The answer lies in Costco’s business model which drives its cost efficiencies and competitive advantages.
Membership Revenue Model
Costco has nearly 78 million paid members as of the end of fiscal year 2024. Its membership model creates a sticky revenue base of loyal customers. Like my father-in-law, consumers are more than willing to pay the membership fees.
Renewal rates have consistently hovered around 93% in the U.S. and Canada (90% including international warehouses). In 2024, Costco raised membership fees for the first time in seven years. While membership fee increases are rare, they have historically had little impact on renewal rates. Costco’s membership fee revenue has grown, on average, 7% per year, and accounts for over half the company’s operating income.
Bulk Pricing & Kirkland Signature
The foundation of Costco’s model is its ability to drive high-volume sales at low margins. These low margins are as a result of Costco passing cost savings on to consumer in the form of lower prices. This is achieved by leveraging its bulk purchasing power, securing lower prices from suppliers, and keeping operational costs low. Its Kirkland Signature brand further strengthens this model.
Costco offers its members quality private-label alternatives at lower prices than name brands. Lower priced essentials reinforces the idea that Costco is an important destination for saving money.
Warehouse Model
Fundamental to Costco’s low prices is the result of its warehouse model. Costco currently operates 890 warehouses globally, with new warehouse openings both domestically and internationally. Costco leverages its warehouse model by getting the most out of each warehouse. This translates to efficiencies in three ways:
- Inventory is stored at the warehouse where it will be sold;
- Relies on high sales per square foot driving down SG&A expenses;
- Offers limited product assortment. This allows Costco to streamline procurement, enhance its supply chain efficiencies, and secure lower costs from suppliers.
All of this results in a more effective and efficient business which enables lower costs for consumers.
This also translates to insulation from threats like macroeconomic issues and competition. The bulk nature of Costco’s offerings makes the economics of delivery an unattractive pursuit for online competitors.
Balance Sheet Strength and ROIC
Further bolstering the low risk perception of Costco is the company’s ‘fortress’ balance sheet which allows for an above average ROIC and positions the company well for reinvestment. Unlike many retailers that rely on debt to fuel expansion, Costco operates with minimal leverage and consistently strong cash flows. Because of management’s financial discipline, Costco is able to reinvest in high-return projects while maintaining profitability.
The result?
- High ROIC: Costco consistently creates economic value by generating returns on invested capital (ROIC) above 20%.
- Low Leverage: The retailer operates with minimal leverage. Because of this, Costco doesn’t rely on debt to fuel growth. Low leverage ratios like net debt to EBITDA ratio of 1.69x, further enhance Costco’s low-risk narrative.
Costco Might Not Be Bulletproof
As is the case for any company, “riskless” does not exist. There are risks to every story, no matter the quality of the company, and that is not different for Costco.
Operating Margin Risks
Among the most concerning are the potential for margin constraints. While we have discussed the value of the low margin nature of the retailer’s business model, Costco does have razor-thin operating margins, around 3.6%. This leaves little room for error. And there are risks to their operating margins.
Labor Costs: On the Q1 2025 earnings call, Costco management acknowledged rising labor costs as an ongoing headwind. In the quarter this caused SG&A to rise 14 basis points year-over-year. Costco pays its employees well above industry averages, but if wage increases continue, this could be a problem for their already thin margins.
Inflation Impact: The challenge with inflation in Costco’s case primarily revolves around logistics, supply chain costs, and fulfillment expenses. While we have discussed the company’s proficiency in these areas, the company is not immune to rising costs. A key value proposition to consumers, as we have discussed, is affordability. Therefore, there may be reluctance to raise prices, despite inflationary pressure which could eat into profitability.
Reliance on Sales Volume: Costco’s business model depends on high-volume. This reliance can pose risks to Costco particularly if there are macroeconomic issues. While economic downturns may drive consumers to Costco, they can also lead to more cautious spending, even on essential items. Any pressure on sales volumes could have meaningful impacts on revenue growth and profitability.
For a company priced for perfection, these are very real threats. Should margins face pressure, the market may perceive these as cracks in Costco’s in the impervious, low-risk narrative.
Valuation Assumptions & Reasonable Price Target
Based on the discussion above, I have structured my valuation model around the following assumptions:
- Revenue Growth: 7% annually. This would be at the high-end of expectation, reflecting successful warehouse expansion, consistent membership growth, and sustained sales volume. Effectively, this would mean that Costco’s value proposition and the strength of the Kirkland brand continue to drive success.
- Operating Margins: Margin expansion from 3.65% in year 1 to 4.0% in year 5. To achieve margin expansion, Costco would need to continue to benefit from efficiencies in warehouse operations most likely due to technology integration like self-checkout and higher-margin e-commerce sales. This would also involve increased penetration of their higher-margin Kirkland Signature products, and assume steady growth of membership fee revenue.
- Capital Expenditures: 1.85% of revenues which reflects historic norms. Costco spent nearly $5 billion on capex in 2024 which is primarily used for new warehouse growth.
- Discount Rate (WACC): 8.5%, which reflects Costco’s low risk profile.
- Terminal Growth Rate: Modeled for 4% and 5%. This assumes that Costco has the potential for long-term sustainable growth above long-term inflation. This assumes long-term pricing power for the company’s membership model driven by its brand strength.
Reasonable Price for Costco
Based on my valuation model, a reasonable price for Costco falls somewhere between $450 and $550 per share. This translates to 25x-30x 2025 estimates. Even pricing in an aggressive growth scenario would return a more reasonable $600 to $650 price.
Yet, here we are with the stock trading above $1,000.
At this level, investors are paying far beyond Costco’s fundamental worth. The market is effectively pricing in decades of premium growth expectations. Even if the company continues to execute flawlessly, it appears there is minimal room for future upside.
Final Thoughts
I admire Costco’s business. It’s predictable, efficient, and resilient. But even the best businesses can become overpriced. For Costco, this appears to be because of the perception that the company can do no wrong, and that nothing will go wrong. Hopefully, I have demonstrated why this perception is not unfounded, but also unrealistic.
Now, I would certainly be a buyer of Costco’s stock again, but that would involve a change. Something like a 30%+ price correction which would bring its stock price closer to fair value. There is also the case where I may have missed a critical part of Costco’s story that may justify the premium, like an unexpected driver of margin expansion; perhaps an acceleration in membership fee increases. I may also learn about a new TAM opportunity.
But short of some change, at today’s levels, Costco is simply too expensive. I will continue holding my position, but I won’t be adding shares for now.
Disclosure: I hold a long equity position in Costco.
