Has Costco Become the Perfect Stock?

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Costco (NAS: COST) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
  • Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at Costco.

Factor

What We Want to See

Actual

Pass or Fail?

Growth 5-year annual revenue growth > 15% 8.1% Fail
1-year revenue growth > 12% 14.1% Pass
Margins Gross margin > 35% 12.6% Fail
Net margin > 15% 1.6% Fail
Balance sheet Debt to equity < 50% 18.4% Pass
Current ratio > 1.3 1.14 Fail
Opportunities Return on equity > 15% 13.1% Fail
Valuation Normalized P/E < 20 25.04 Fail
Dividends Current yield > 2% 1.1% Fail
5-year dividend growth > 10% 12.7% Pass
Total score 3 out of 10

Source: S&P Capital IQ. Total score = number of passes.

Since we looked at Costco last year, the company has actually improved its score by a point, as its revenue growth over the past year has risen sharply. Despite its low score, the retailer has masterfully navigated a low-margin industry, but some now wonder what its future will look like with a new CEO.

Costco is well-regarded as a leader in the big-box retail industry, with its warehouse membership model producing profits not only from selling goods but also from annual fee revenue. With an emphasis on customer service, employee retention, and low prices, Costco has seen much faster growth than Wal-Mart (NYS: WMT) and Target (NYS: TGT) both recently and over the past five years. In fact, its business model is one that international peer PriceSmart (NAS: PSMT) has also executed well, bringing good results for the business and its shareholders.

Despite its obvious appeal to bargain-hunters, Costco appeals to higher-income customers than ultra-discounters like Dollar General (NYS: DG) . That gives Costco more stability, especially with membership retention rates approaching 90%. And although the company is raising its membership fees, there are good reasons to think that Costco won't have the same uprising among its members that Netflix (NAS: NFLX) saw with its increase earlier this year.

One of Costco's biggest pushes over the years has been toward building e-commerce sales. Although its online operation will never rival Amazon.com (NAS: AMZN) , Costco nevertheless sold $1.7 billion in goods through its Internet site last year. That's only around 2% of total revenue, but for a business founded on bringing people in the door, it represents a shift in thinking for the company -- and a potential source of growth for the future.

With CEO Jim Sinegal retiring, some fear that Costco's magic could go away. But with the system Sinegal put in place, his successor should be able to push Costco closer to perfection in the years to come.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.

Click here to add Costco to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

Finding the perfect stock is only one piece of a successful investment strategy. Get the big picture by taking a look at our " 13 Steps to Investing Foolishly ."

At the time this article was published Fool contributor Dan Caplinger doesn't own shares of the companies mentioned. The Motley Fool owns shares of Costco and Wal-Mart. Motley Fool newsletter services have recommended buying shares of Amazon.com, PriceSmart, Wal-Mart, Netflix, and Costco, as well as creating a diagonal call position in Wal-Mart. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


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