Multiple Compression May be a Risk for Costco Stock

First off, I’ll admit it may sound foolish to be bearish on Costco Wholesale Corp. (NASDAQ:COST) stock. But my bearishness isn’t built around any issues with the company’s underlying business.

Mainly, because there are not too many. The membership-based discount retailer keeps reporting strong results. It thrived during the pandemic. It’s still thriving during the recovery. Per my InvestorPlace colleague Joel Baglole, there’s a good chance not even high inflation affects its operating performance.

It’s tough to deny that the business is still firing on all cylinders. Yet this doesn’t necessarily mean Costco will hold onto, much less add to, its current valuation. Costco’s current forward price-earnings (P/E) multiple is out of whack with its growth potential.

During a time of near-zero interest rates, this may have been sustainable. With stocks the only game in town for positive real returns, it made some sense to give some high-quality stocks frothy valuations.

However, with the Federal Reserve on track to raise rates, perhaps to a greater extent than currently anticipated? The end result may be a sharp pullback for shares.

The Latest With COST Stock

For the past month, Costco shares have more or less traded sideways. On one hand, the flight to quality stocks has been to its benefit. With elevated fears about inflation, interest rates, and Russia, many investors have turned to it as a safe harbor.

On the other hand, while inflows have enabled it to avoid a big sell-off, the market has been unwilling to bid up COST stock. Not even a strong quarterly earnings report released on March 3 was enough to renew excitement. Its revenue and earnings numbers for the quarter came in ahead of expectations.

Still, there was a mixed reaction to the report. Some may chalk this up to the slowdown in its e-commerce sales growth. But the stock’s valuation may be what’s keeping investors from sending this back up to its previous all-time high ($571.49 per share, just a few percentage points below what it trades for today).

Worse yet, this hesitancy to bid it back up could morph into a big move lower for it. Especially once the Fed’s rate hikes are in full swing.

What Could Put Pressure on Costco’s Valuation

COST stock may still seem unsinkable, as it’s managed to fall by just a few percentage points in recent months, despite the upheavals. Even so, there are two factors that point to it moving a lower valuation, and hence, a lower stock price.

First, like I mentioned, Costco’s valuation (forward P/E of 40.6x) is way too high compared to its expected earnings growth. While it did report very high earnings growth (24.9%) last fiscal year (ending August 2021), this growth is set to slow down this fiscal year (to 15.3%) and the next (to 9%). This could put pressure on its valuation.

Second, the raising of interest rates stands to push its valuation back to historic norms. Much of its big run-up since 2020 has been due to multiple expansion, a product of near-zero interest rates justifying historically high valuations for stocks. As interest rates move back up, multiples will compress in response.

So, what could this mean for its stock price going forward? Best case scenario, we could see just a modest amount of compression. After all, on the eve of the pandemic, it was trading for between 30x and 34x earnings, above the 20x-30x it traded for in previous years.

Based on earnings per share (EPS) projections for fiscal year 2023 ($14.21), that implies a target price of between $426.30 and $483.14 per share, or  8.1% to 18.8% downside.

Worst case scenario? A move to the mid-point of its historical valuation (25x) would still keep it at a premium to other large discount retailers, like Walmart (NYSE:WMT). It would also mean tremendous downside from today’s prices. Put a 25x multiple on its 2023 projections, and the stock would be worth just $355.25 per share. That’s around 32.4% below what it trades for today.

The Bottom Line

It may sound far-fetched to say COST stock could drop by nearly a third, just on valuation concerns. But I wouldn’t discount the possibility that inflation fails to come down, forcing the Fed to implement rate hikes far more severe than expected today.

Even if my more “doom and gloom” forecast fails to pan out, even a moderate amount of multiple compression, driven more by slowing earnings growth, could mean moderate losses for investors buying it today.

If you’re looking for safe harbors in today’s market, stick to more modestly-priced blue chips. Hold off on COST stock.

On the date of publication, Thomas Niel did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.