Wal-Mart Stores, Inc. (WMT), Costco Wholesale Corporation (COST): Why This Huge Discount Store Keeps Growing

 Valuation

Costco isn’t particularly cheap. Using Oldschoolvalue financial spreadsheets, I ran a discounted cash flow model to estimate Costco’s fair value. I used a 3% terminal growth rate and 9% discount rate assumptions. In order to justify Costco Wholesale Corporation (NASDAQ:COST)’s current stock price, the company would need to grow its free cash flow for the next 10 years at around 18% annually, which is very optimistic because the average growth rate for the past 10 years was slightly above 12% per year. This scenario gives a $113 price target, $2 above the current stock price.

My estimate is not too “unrealistic” according to the Street consensus, which is $116.23 per share according to Yahoo! Finance. Morningstar optimistically gives a fair value of $115 per share.

In conclusion, we could say that at the moment Costco seems fairly valued. An interesting entry point could be $105 per share, which represents a 5% correction. This could materialize if Costco misses the consensus due to over-expectations.

Final foolish thoughts

Due to its membership-only system, Costco’s a unique warehouse stock with attractive high margins and downside risk limited by more than $3 billion in revenue coming from fees secured one year in advance.

With a net loss of $348 million ($1.58 per share) in the first quarter, J.C. Penney’s profitability is far away from Costco’s. Increasingly price-sensitive consumers are leaving the store in droves.

An absence of sustainable competitive advantages has taken this legendary company very close to bankruptcy. According to a recent press release, cash amounted to $1.535 billion, while total debts were $5.82 billion at the end of the quarter. The company is clearly running out of both time and money.

Wal-Mart, on the other hand, has more stable and safe cash flows, but it faces a challenging trade-off between profitability and growth. The company has reached a size where the only way to keep growth positive is to increase discounts. This hurts profitability.

Notice that Wal-Mart Stores, Inc. (NYSE:WMT) already has 6,242 international stores and is finding it increasingly difficult to keep annual revenue growth in the 2% range.

With only 170 warehouses abroad, Costco’s growing fast in Asia and has plenty of room left for further growth. It makes sense to assume a relatively high growth rate for the next 10 years. Unfortunately, the current stock price is too close to the company’s fair value, but investors should watch for market corrections.

The article Why This Huge Discount Store Keeps Growing originally appeared on Fool.com and is written by Adrian Campos.

Adrian Campos has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.