Imagine if for $1 million you could buy a business that makes $100,000 in annual profit. In investing lingo, one would say this business trades at 10 times its earnings or at a price-to-earnings (P/E) ratio of 10. It’s helpful. In this particular scenario, one would recoup the purchase price after 10 years. Year 11 and beyond would allow the investor to make serious money.
Of course, it’s an over-simplistic way of looking at things. In the real world earnings are rarely static. But it still demonstrates how a P/E ratio works and why one would want to buy a business at a lower P/E ratio if at all possible.
Buying shares of Costco Wholesale (COST 0.88%) at a lower P/E ratio is not possible right now. As of this writing, Costco stock trades at 55 times its earnings, which is just the second time in its history that its P/E ratio has gone over 50.
COST PE Ratio data by YCharts
Costco stock is up approximately 60% over the past year, which is crushing the S&P 500 and consequently attracting at lot of attention from investors. But should investors buy with the P/E ratio this high? Well, investors can use history to guide that decision.
Here’s what happened last time
In early 1999, Costco stock jumped up over 50 times its earnings. The famous dot-com bubble in the stock market was in full force at the time. Costco stock would go on to hit an all-time high (at the time) in early 2000 right as the stock market bubble was about to pop. It eventually did pop and Costco stock lost roughly 50% of its value by the end of 2002.
Keep in mind that Costco’s business continued to perform quite well over this time. From the start of 2000 through the end of 2002, both revenue and earnings per share (EPS) were up. But the stock still got cut in half.
One might argue that it’s irrelevant to note that Costco’s P/E ratio was over 50 at the time. After all, when a bubble pops, almost all stocks go down regardless of valuation. But one could also argue that Costco’s lofty valuation was the direct result of the bubble, making it very relevant indeed.
It’s possible that the S&P 500 is currently in bubble territory yet again. From a P/E ratio perspective, the S&P 500 currently trades at its second highest valuation since the dot-com bubble popped over 20 years ago. The only other time it was pricier was in 2021, right before it plunged in 2022.
In other words, Costco’s P/E ratio is over 50 again and an overvalued market could be the culprit, just like in 2000. And back then, Costco stock wound up dropping by over 50%.
Here’s what will probably happen this time
A lofty P/E ratio is usually only appropriate when 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 the stock drops in the near future like it did over 20 years. In short, I’m comfortable saying it’s overvalued today.
But there’s more to the story. It’s true that Costco stock dropped, which was tragic for any investor who invested all of their money at the top. But the company has a great business model and it eventually regained highs and has been an extraordinary long-term investment, gaining over 1,900% since 2000.
In other words, Costco stock was a great stock to dollar-cost average into when its P/E ratio was over 50. Consider the potential returns from the table below.
| Investment Date | Investment | Percentage Return by 2010 | Value by 2010 |
|---|---|---|---|
| Jan. 1, 2000 | $1,000 | 58% | $1,583 |
| Jan. 1, 2001 | $1,000 | 81% | $1,808 |
| Jan. 1, 2002 | $1,000 | 63% | $1,627 |
| Jan. 1, 2003 | $1,000 | 157% | $2,573 |
| Jan. 1, 2004 | $1,000 | 94% | $1,942 |
| Total | $5,000 | 91% | $9,533 |
Data source: YCharts.
If someone invested all of their money in Costco stock at the valuation peak, it took awhile to recover. And 10-year returns of 58% weren’t fantastic. But by continuing to invest in a top company such as Costco over time, investors were able to greatly improve their long-term returns while avoiding being the victims of 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 exact moment. That said, I also believe that Costco is one of the best and most resilient businesses around, meaning this is a stock that’s worth holding in a portfolio.
For those who agree with me regarding the quality of Costco’s business, I think it could be a great idea to space out an investment over the next several years. This will help you avoid the risk of buying overvalued shares before a potential drop in the market.
Jon Quast has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Costco Wholesale. The Motley Fool has a disclosure policy.
