Forecast: Costco stock to underperform S&P 500 over next 5 years

One of the best-performing stocks in recent years couldn’t be further from the technology sector or the ongoing artificial intelligence (AI) boom. I’m talking about Costco (COST -0.24%)The warehouse club operator’s shares have delivered a total return of 233% over the past five years, outperforming S&P500 by 96%.

While retail stock continued its momentum through 2024, I’m not bullish on the future. I predict Costco will underperform the S&P 500 over the next five years.

Costco is a high-quality company

First, it’s important to set the tone. Costco is a very good business and has many positive attributes that investors appreciate.

It is the world’s third-largest retailer, a position that gives Costco enormous economies of scale. Because of its huge sales combined with far fewer SKUs in its stores, the company can leverage its incredible buying power with suppliers, getting favorable prices on its goods. Costs are continually passed on to shoppers in the form of everyday low prices.

This advantage increases the sustainability of Costco’s business – the risk of business disruption is minimal. In addition, the company’s membership model creates a high-margin, recurring, and predictable revenue stream. With a global renewal rate of 90.5% in the last fiscal quarter (Q3 2024 ended May 12), customers are very loyal.

It’s no wonder that Warren Buffett’s longtime right-hand man, the late Charlie Mungerwas a huge fan of the business. “I love everything about Costco,” Munger once said. “I’ll never sell a stock.”

Where is the margin of safety?

Consistent, consistent financial performance—namely, solid revenue and earnings growth over the long term—has made Costco stock a favorite buyer. But I think the market’s love affair with the business has gone too far.

Let’s consider valuation, which should be a key part of any investor’s analysis. At the time of writing, Costco shares are trading at price to profit P/E ratio of 52.9. In the entire history of the company, the highest price was sold for a P/E ratio of 56.4, which took place in 1999. Currently, the shares are very expensive and I don’t think anyone would disagree with that.

There is absolutely nothing safety margin inherent in the current stock price. The market is pricing the stock as if Costco could do no wrong, so there is significant downside risk. If Costco misses Wall Street estimates by even a small amount, or investors become slightly less optimistic about its prospects, the stock could fall, leading to portfolio losses.

To be fair, if Costco were to grow net income quickly, it would make sense to pay 53 times earnings. But that’s not the case. The consensus analyst estimate is for the company to grow earnings per share at a compound annual rate of 10.7% between fiscal 2023 and fiscal 2026. It’s a massive and mature company, so earnings are likely to decline over time.

Observant readers will dismiss my argument that stocks are expensive by saying that they have always been that way. For example, exactly 10 years ago, the stock traded at a P/E of 26.6, which was expensive at the time. But since then, the stock has soared 616%.

It is worth mentioning that the P/E has increased by almost 100% during this period. Can a rational and prudent investor really believe that Costco stock will not only double its P/E but also see any positive multiple expansion over the next five years? I believe there is a strong possibility that the valuation multiple will decline.

This will create a strong headwind working against investors. That’s why I think stocks will underperform the broader index through 2029.