Shares of Costco (NASDAQ: COST) are up 54% over the last 12 months, but most of that return was driven by an increase in the price-to-earnings (P/E) multiple that Wall Street is willing to pay for the shares -- not actual growth in the company's earnings per share.
Analysts expect Costco to report annualized earnings growth of 9% over the long term, yet the stock trades at a price-to-earnings ratio that is usually reserved for the best growth stocks. Costco's forward P/E of 45 is even more expensive than some of the world's strongest tech companies, including top Magnificent Seven stocks Amazon (NASDAQ: AMZN) and Nvidia (NASDAQ: NVDA), which are expected to grow earnings faster and trade at lower valuations.
Costco is a retailer trading at a growth tech stock valuation, and Wall Street has made this mistake before. In the late 1990s, shares of Coca-Cola and Walmart traded at over 50 times earnings. The subsequent returns over the next decade were disappointing, as these stalwarts couldn't deliver enough earnings growth to support their high valuation.
The key to success in the stock market is to always go for strong businesses that offer the best growth prospects at a relatively attractive valuation. This framework says to pass on Costco right now, because there are plenty of growth stocks offering better value. These Magnificent Seven stocks are a good place to start.
1. Amazon
Amazon is one of Costco's chief competitors in e-commerce. To its credit, Costco is growing its online sales faster than Amazon. Costco's e-commerce business grew sales 19% year over year on an adjusted basis in the fiscal quarter ending Sept. 1. This beats Amazon's single-digit growth from online stores.
Costco has the benefit of growing from a smaller base of online sales than Amazon. Amazon controlled 37% of the domestic e-commerce market in 2023, according to Statista, compared to 6% for No. 2 Walmart. Costco was in a distant seventh place with 1.5% share.
However, considering all of Amazon's revenue sources -- including advertising, cloud services, subscription services, and physical retail locations -- it's better positioned to deliver superior returns to investors. Amazon's total revenue grew 10% year over year in the second quarter. Over the last 10 years, Amazon grew sales at a 22% compound annual rate, compared to just 8% for Costco.
Moreover, Amazon is implementing several cost-cutting initiatives to bolster its profits. Operating income grew 91% year over year last quarter, as management continues to shorten transportation distances between fulfillment centers and customers' doorsteps. In contrast, Costco's operating profit grew just 9% year over year last quarter.
Importantly, most of Amazon's operating income comes from its cloud services business. Amazon Web Services is the top cloud provider in a $297 billion market that grew 22% in Q2, according to Synergy Research. The lucrative revenue streams Amazon generates from non-retail services like cloud computing are a major advantage over traditional retailers. They allow Amazon to be more aggressive in investing in e-commerce infrastructure to protect its lead.
Analysts expect Amazon's earnings per share to grow 23% on an annualized basis over the long term. The stock's forward P/E is 39 on 2024 earnings estimates, which is a discount to Costco shares, and should lead to better returns.
2. Nvidia
Nvidia shares have delivered incredible returns of over 2,700% over the last five years. Some investors might look at that amazing run and assume the stock is overvalued. But this top semiconductor company is benefiting from powerful trends in artificial intelligence (AI) and data center growth that could fuel more market-beating returns.
Wall Street has underestimated the market for Nvidia's graphics processing units (GPUs). GPUs were originally used in the 1990s for playing video games and running other graphics-intensive computer software. But in recent years, Nvidia's chips have run some of the most powerful supercomputers in the world.
The company estimates that there is about $1 trillion worth of data center infrastructure in the process of switching from legacy computing hardware to more powerful GPUs that are needed to accelerate computer processing for AI workloads. As a result, Nvidia's revenue has accelerated over the last few years, as data centers build more optimized infrastructure to train AI models, which require tremendous amounts of data and computing horsepower.
It's important to be aware that, as a leading company in a cyclical chip industry, Nvidia's revenue growth hasn't been as consistent as Costco's. But investors are being well compensated for accepting a more bumpy ride.
Analysts expect Nvidia to deliver 38% annualized earnings growth over the next several years. Nvidia's earnings jumped 168% year over year in the most recent quarter. This is thanks to a shortage in AI chips relative to demand, which is allowing Nvidia to charge high prices. Over the last 10 years, Nvidia's earnings grew at a compound rate of 51%. The opportunities ahead in the data center market should continue to drive stronger growth and returns for shareholders than Costco shares.
Nvidia currently trades at a forward P/E of 49. But using next year's earnings estimate, the stock trades at a forward P/E of 34, compared to a more expensive 45 multiple for Costco.
Don't pay a high P/E for below-average growth
There is a right time to pay a high valuation for a stock, but there are also wrong times. To justify a high P/E, the company needs to deliver lots of earnings growth. Amazon and Nvidia are meeting those expectations, but investors should think twice before paying a high P/E for Costco's single-digit sales and earnings growth.
There are plenty of expensive-looking growth stocks that have crushed the stock market's average return, but Costco can't be considered a growth stock when it's not growing earnings higher than the average company in the S&P 500 index.
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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. John Ballard has positions in Nvidia. The Motley Fool has positions in and recommends Amazon, Costco Wholesale, Nvidia, and Walmart. The Motley Fool has a disclosure policy.
Should You Buy Costco Stock? These "Magnificent Seven" Stocks Are Cheaper and Growing Faster was originally published by The Motley Fool