Valuation and analysis Essay

Executive Summary

The planetary recession has created attractive investing chances in the stock market. Based on the past 10 post-WWII recessions, Standard & A ; Poor ‘s 500-stock index has gone up, on norm, 32 % one twelvemonth after the market hits bottom during an economic downswing. [ I ] Given this statistic, investors may be inclined to buy stocks without equal cognition. While chances exist, it is of import to analyse companies and value their portions to assist choose undervalued stocks. The residuary income theoretical account, or RIM, is peculiarly utile since it offers a practical manner to measure companies in any economic environment. [ two ]

The followers is a comprehensive rating of Costco Wholesale Corporation, utilizing the RIM model. Based on the analysis that follows, the ensuing recommendation is to short the Costco stock since it is significantly overvalued.

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Industry Overview

Costco is classified as a Warehouse Club and Superstore, and hence competes in the industry with other retail merchants such as Sam ‘s Club, BJ ‘s Wholesale, and Meijer. This industry is extremely competitory and dominated by a few big companies ( including Costco ) that control some 90 % of the market in the U.S. Annual industry grosss in 2008 were estimated at over $ 350 billion ; a market that has seen gross revenues increase by 35 % over the last decennary. [ three ] Demand in this industry is driven chiefly by demographics and additions in little concerns, and is significantly impacted by fluctuating trade good monetary values, foreign exchange rates, and consumer disbursement tendencies ( see Exhibit 1: PEST Analysis ) . Large ironss tend to rule the market as they can take advantage of greater buying power, sophisticated distribution channels, and favorable funding footings. Profitableness is dependent on a high volume of gross revenues, low cost buying, and efficient distribution which is achieved by offering a low figure of stock maintaining units ( or SKUs ) per warehouse, intending that the companies limit the figure of merchandises offered, yet offer a wider scope of ware classs, most of which are sold in big sizes or majority.

This industry is ill-famed for its low gross borders due to the intense competition for low costs, which is sustainable due to high volume buying and stock list turnover. Warehouse nines offer a no-frills, self-serve shopping experience across merchandise classs such as nutrient, mass ware, pharmaceutics, and electronics. A critical facet of the concern theoretical account is the rank fees and renewal rates ; the principal distinguishing factor between warehouse nines and superstores.

An rating of the industry ( see Exhibit 2: Porter ‘s Five Forces ) identifies competitory competition and handiness of replacements as the two chief menaces to cardinal participants. The figure of direct and indirect rivals for the sale of nutrient and consumer goods, including supermarkets, section shops, and the coming of the superstore, do this industry extremely susceptible to replacements as low pricing is the cardinal success factor in the industry. The menace of new entry is average given that there are comparatively few barriers to entry ; nevertheless the ability to supply low monetary values is contingent on economic systems of graduated table and favors larger, established companies. While purchasers have no bargaining power, purchaser power is medium/low due to low shift costs to other retail merchants. Finally, supplier power is low due to the low figure of SKUs offered in-store and the easiness with which retail merchants can replace points with viing merchandises.

Company Overview

Costco Wholesale Corporation pioneered the rank warehouse construct in 1993, and has since grown its concern to over $ 70 billion in grosss. The company operates 559 warehouses in 8 states ( though 70 % of warehouses are located in the US ) and employs over 142,000 people. It offers a broad assortment of merchandises in-store and on-line ( in the US and in Canada ) , including food markets, electronics, contraptions, automotive supplies, jewellery, and office equipment. In add-on, Costco offers services such as insurance, funding, optical Centres, pharmaceuticss, and self-serve gas Stationss.

Costco boasts the highest rank reclamation rate in the industry at 87 % which represented 2.19 % of net gross revenues for FY2009, showing member satisfaction with the cost/benefit of their rank dollars.

Costco ‘s scheme is based on offering a limited choice of the best merchandising national trade names every bit good as their ain private label merchandises ( under the trade name name “ Kirkland Signatures ” ) to bring forth high gross revenues volumes and rapid stock list turn-over. To maximise distribution efficiencies and lower receiving costs, Costco purchases ware straight from makers and has containers delivered at one of its 16 cross-docking installations that distribute merchandises straight to its warehouses, where the goods are sold straight off the transportation skids. The company ‘s mean gross revenues per warehouse is the highest in the industry at $ 135M, more than twice that of its closest rivals ( see Exhibit 3: Cardinal Performance Metrics ) . In add-on, Costco ‘s inventory turn-over rate for 2009 was 11.9 % , one of the highest in the industry, showing that the company ‘s scheme is bring forthing the coveted consequences. However, Costco ‘s gross borders are among the lowest among its rivals at merely 2.5 % of net gross revenues for FY 2009, meaning that company public presentation is extremely dependent on gross revenues volume, and besides highlights the importance of commanding SG & A ; A costs.

Costco has taken on a figure of strategic enterprises, including its enlargement into the Asiatic market with shop gaps in Korea, Taiwan, and Japan ; every bit good as its first warehouse gap in Australia. In add-on, the company invested in extra services for real-time scan and stock list informations from over 70 Costco warehouses across Canada to supply market intelligence and “ real-time ” consumer disbursement informations in an attempt to better client swerving capablenesss. Finally, the company ‘s aggressive stock buy backing plan has seen it purchase back about 17 % of outstanding portions worth about $ 57M.

Fiscal Analysis

Key Considerations

Costco is positioned to stand out in the sweeping nine retail industry as the market recovers from this latest recession as it attracts a more flush patronage than price reduction shops like Wal-Mart or Target. Around 24 % of Costco ‘s clients have incomes over $ 100K. [ four ] The more flush patronages tend to be at the head of consumer disbursement in a retrieving economic system.

Management has indicated that Costco ‘s long-run gross border mark is 3.5 % , up from the current FY2009 border of 2.5 % . Margins are expected to better thanks in portion to the planned enlargement of its private label trade name, “ Kirkland Signature ” , which was launched in 1995. This will supply the company with greater control over its supply concatenation, sourcing costs and merchandise quality and stock list. At a recent analyst / investor meeting held at the company ‘s new nine gap in Manhattan this past November, direction announced its purposes to turn its private label trade name from the current degree of merely under 20 % of overall ware mixture to over 30 % by 2012. Private label trade names are turning in popularity in today ‘s economic system, peculiarly among price-conscious consumers. This demand for private label merchandises is forecasted to go on turning, as these merchandises are progressively comparable in quality to popular trade name names, and offer an attractive ‘value for money ‘ characteristic. [ V ] As private labels capture market portion from national trade names, the latter may be forced to go through along more nest eggs to the consumer, which will take to farther betterments in borders for Costco. Costco will besides go on to accomplish efficiencies in merchandise packaging, farther cut downing its costs and lending to its long-run gross border end.

New shop gaps are expected to speed up in new and bing markets from the trough degree of merely 15 shops in financial 2009. Costco opened its first shop in Australia in August of this twelvemonth, perforating a new, attractive market with growing potency in the locality of 20 shops. The company is be aftering 15-20 new nines in financial 2010, 20 new gaps in both 2011 and 2012, and more than 25 per twelvemonth in 2013 and 2014. Management has indicated its desire to make 30 new gaps per twelvemonth ( as it had reached in financial 2007 ) in the long-run, and has programs to run every bit many as 100 warehouse nines across its three Asiatic states ( Japan, Korea, and Taiwan ) versus the 22 nines it soon operates. As Costco continues to turn, it stands to derive more control over its providers thanks to its turning volume of gross revenues.

Costco presently uses the LIFO accounting method in describing its U.S. stock lists, which leads to higher recognized costs of gross revenues and reduces nonexempt income. The International Financial Reporting Standards ( IFRS ) , scheduled to be adopted by U.S. houses get downing in 2014, explicitly disallows the usage of LIFO due to its possible to skew stock list values. [ six ] The acceptance of IFRS in the States could ensue in companies incurring a potentially astonishing cost upon the alteration to FIFO. [ seven ] Preliminary estimations indicate that losingss from revenue enhancement nest eggs for all US companies doing the switch to FIFO, at an estimated $ 106 billion over a 10 twelvemonth period. [ eight ]

The acceptance of IFRS will non be compulsory until 2014. Yet beyond the loss of revenue enhancement benefits, IFRS regulations besides impact regulations regulating rentals, impairment attacks, durable and indefinite assets, and belongings, works and equipment.

On-line retail disbursement in the U.S. was $ 128.1 billion in 2007 and is expected to make $ 214.8 billion by 2012, at a compounded one-year growing rate of 10.9 % for the period 2007-2012. [ nine ] Costco direction has targeted to turn its online concern to $ 5 billion in the following few old ages from its current $ 2 billion degree in FY2009. Online gross revenues provide runing cost benefits to Costco by cut downing shop stock list cost.

The competitory landscape is besides forecasted to alter, as competition among rivals ‘ intensifies. Wal-Mart late announced its purposes to cut back on monetary values and spread out its nutrient ware in its Sam ‘s Clubs, boldly saying its scheme to steal clients from challengers like Costco by concentrating on fewer but bigger enterprises. [ ten ] The impact on Costco ‘s grosss could be important.

RIM Inputs

Costco ‘s Cost of Equity

The cost of equity for Costco was calculated utilizing the Capital Asset Pricing Model ( CAPM ) equation. As recommended by Grabowski, we applied the mean long-run 20-year T-bond output of 4.20 % as the hazard free rate and 6.0 % as the equity hazard premium given the current market conditions. [ eleven ]

Costco ‘s 60-month historical beta based on the company ‘s capital construction and covariance of stock returns with the S & A ; P index is listed as 0.78. [ twelve ] We verified the beta for appraisal mistake and purchase accommodation by gauging unlevered betas for a group of houses in the same concern ( see Exhibit 4: Costco Cost of Equity ) . We averaged the unlevered betas and so re-levered the beta for Costco utilizing the mean industry-wide debt/equity ratio. This resulted in a beta of 0.87. Given these inputs, we can cipher the cost of equity for Costco, which is estimated to be

EPS Prognosiss

We used mean analyst prognosiss of EPS over the following five old ages. In the close term ( for 2010 and 2011 ) , we used the norm of over 20 analyst prognosiss ( see Exhibit 5 ) as reported on NASDAQ. These were found to be $ 2.89 and $ 3.22, severally. Harmonizing to Bradshaw, a five-year skyline corresponds to the skyline of long-run net incomes growing prognosiss. [ thirteen ] The mean long-run net incomes growing prognosis of 12.73 % [ xiv ] , based on over 12 analyst anticipations, was hence used to calculate EPS for 2012, 2013 and 2014.

Dividend Payout

Costco ‘s 10-K study indicates that profitableness and expected capital demands are the two cardinal factors that determine the dividend payout. Historical information was later analyzed to find the payout ratio traveling frontward ( See Exhibit 5: Dividend Payout ) .

Costco began paying dividends in 2004. The growing tendency in dividends, EPS and capital outgos from 2004 through to 2009 were reviewed. Despite a negative net incomes growing and a negative growing in capital outgos in 2009, Costco increased its dividend payout to 27.3 % from 20.7 % in 2008. While the determination to increase the dividend payout in 2009 tallies contrary to the stated payout finding factors, it signals directions ‘ belief in Costco ‘s future net incomes potency.

Given the incompatibilities in Costco ‘s dividend policy, we will presume that Costco will go on its most recent dividend payout of 27.3 % . The premise that houses will go on their recent dividend payout policies is consistent with anterior research. [ fifteen ]


Costco ‘s stock monetary value on November 27th, 2009 was $ 60.03. The per portion book value, as reported in the 10-K as of August 30th, 2009 is $ 22.98. Using the RIM inputs, we begin by finding the value of the stock that can be explained by the book value and the present value of the residuary income for the following five old ages. As illustrated in Exhibit 6: Rim, merely 45 % of the current stock monetary value, or $ 27.02, can be attributed from the book value and the first 5 old ages of RI. Therefore, at least 55 % , or $ 33.01, would necessitate to be derived from the present value of the go oning value in order to warrant the current stock monetary value.

Continuing Value Scenarios

The return on common stockholders ‘ equity, or ROCE, is turning over the five twelvemonth period and remains 3 to 4.5 % above Costco ‘s estimated cost of equity of 9.4 % . Since ROCE is a cardinal statistic used to calculate RI [ xvi ] , we can presume that RI will go on to turn for some clip or at best will stay changeless after the five twelvemonth period.

The undermentioned four scenarios were used in finding Costco ‘s go oning value:

  1. Changeless growing of RI after 2014: Assuming that the estimated RI of $ 1.51/share in 2014 continues in sempiternity ;
  2. Turning RI after 2014: A growing rate of 5 % to sempiternity was applied based on gross border betterments and the potency of perforating bing and new markets ;
  3. Fading RI after 2014: A fade rate of 0.80 is assumed, which falls at the high terminal of the industry-specific scope [ xvii ] due to the adulthood of the industry ;
  4. RI turning for 5 old ages, so melting: A growing rate of 5 % for five old ages based on the grounds mentioned above, followed by a fade rate of 0.68 ( mean estimation consistent with empirical grounds that shows that the return on equity reverts to the cost of capital over about 10 old ages [ xviii ] ) .

Based on our analysis of the industry and company, the most optimistic instance for Costco would be to keep a changeless RI. A more realistic instance would be the turning and melting RI scenario. As illustrated in the above tabular array, neither scenario justifies the November 27th stock monetary value of $ 60.03.

We besides ran a sensitiveness analysis to find the impact of a alteration in the cost of equity on the ratings. The 3rd column of the above tabular array displays the changing stock monetary values for each scenario based on a cost of equity of 8.6 % , which is calculated utilizing the CAPM equation with a 5 % equity hazard premium instead than the more conservative 6 % . As we can see, the current stock monetary value still can non be explained, with both selected scenarios gauging that the stock is presently merchandising at 30-50 % over value.

Reverse Engineering

We reverse-engineered RIM to find the residuary income growing rate after 2014 that would warrant a stock monetary value of $ 60.03 ( See Exhibit 7: Reverse Engineering ) . The implied residuary growing rate for Costco to be merchandising at this monetary value is 6.3 % . This is a extremely improbable scenario given that Costco is in a extremely competitory industry, and academic research has shown that merely a really little per centum of public companies can anticipate to turn RI indefinitely. [ nineteen ]


Based on our analysis, we recommend shorting the Costco stock. Harmonizing to our RIM analysis, the stock should be merchandising around $ 32 to $ 42.

  1. Bickers, Amy, “ Stockss to Buy Before the Recovery ” , Kiplinger Personal Finance ( August, 2008 ) . hypertext transfer protocol: //
  2. Thornton, Daniel B. , “ Rim Fundamentalss: An Introduction to the Residual Income Model for Valuing Companies ‘ Stockss ” , Queen ‘s School of Business ( September, 2009 )
  3. Industry Overview: Warehouse Clubs and Superstores, Hoovers ( accessed December 4, 2009 ) hypertext transfer protocol: // — ID_316 — /free
  4. Strasser, David, “ Foregrounding a Long-run Narrative ” , Janney Capital Markets ( November 12, 2009 )
  5. Palmer, Alex, “ Private Labe Turning Quickly ” , Brandweek ( Sept 22, 2009 ) hypertext transfer protocol: //
  6. “ International Financial Reporting Standards: Considerations for the Retail Industry ” , Deloitte
  7. Must LIFO Go to Make Way for IFRS? Accounting Methods & A ; Periods. Hoffman, Michael. McKenzie, Karen
  8. Ibid.
  9. Costco Wholesale Corporation. Datamonitor ( March 18, 2009 )
  10. D’Innocenzio, Anna, “ Sam ‘s Club Plans to Cut Monetary values, Offer more Necessities ” , The Ledger ( October 23, 2009 )
  11. Grabowski, Roger J. , “ Cost of Capital Estimation in the Current Distressed Environment ” , The Journal of Applied Research in Accounting and Finance. Volume 4, Issue 1 ( 2009 )
  12. Capital IQ
  13. Bradshaw, Mark T. , “ How do Analysts Use Their Net incomes Prognosiss in Generating Stock Recommendations? “ , The Accounting Review. Volume 79, No.1 ( 2004 )
  14. Capital IQ
  15. Ibid.
  16. Supra note 2
  17. Supra note 11
  18. Supra note 11
  19. Supra Note 2

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