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Ken is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
One critical aspect of successful investing is buying solid, well run businesses; another is buying them at the right price. Astute investors are always careful to identify the dominant companies within a market segment and then to allocate their capital to those companies that are selling at the most attractive price of that group.
In the discount retail space, Costco (NASDAQ: COST), Wal-Mart (NYSE: WMT) and Target (NYSE: TGT) are three names that have to be included in any discussion of well managed businesses that are household names in the space.
Customer surveys of Costco members, who pay a fee for the privilege of shopping in the stores, indicate a satisfaction level that could almost be described as cult-like, if we weren’t talking about a discount retail buyers club. They absolutely love the stores and shopping in them. Any business that delivers this level of customer satisfaction and loyalty deserves close examination and consideration for investment. But would we be buying at the right price?
Costco shares currently change hands at a forward P/E multiple of 21.2 with a 5-year projected earnings growth rate of 13.1%. While the shares have a dividend yield of 1.04%, the payout ratio required to achieve this dividend is 183% and with a valuation equal to 17.3 times cash flow, we have an excellent business that is already priced to produce exceptional future results. The razor-thin net profit margins of 1.7% over the last five years make it difficult to see how positive surprises could be delivered.
Looking to the giant of discount retail and the unquestioned dominant participant within this segment of the retail industry, our attention turns to Wal-Mart. With a market capitalization over five times that of Costco or Target, it is truly the giant of discount retailing; that is both good news and bad news for the shareholders. The good news is that its size does bring some degree of stability and safety; the bad news is Wal-Mart’s size means it takes a lot of dollars in profit growth to generate even a small amount of growth when calculated as a percentage, which is how businesses tend to be valued by the market.
Sporting a forward P/E multiple of 12.73 and forward projected annual earnings growth for the next 5-years of 9.6%, the business carries a very reasonable price to earnings growth multiple of 1.33. As we further consider the price to cash flow multiple of 9.4, net margins of 3.7% and a 5-year return on equity average of 21.9%, we have a large, stable business, very fairly priced. Throw in the annualized 12.56% rate of increase in the dividend (currently yielding 2.51%) and investors should be able to expect to receive a very steady total return of 10%-12% a year between dividends and equity appreciation by holding this stock for years to come – excellent returns for a safe investment.
In reviewing the forward prospects for Target, possibly Wal-Mart’s most dangerous competitor, we see a business that is producing performance numbers closer to Costco but priced in the market with valuations more in line with the slower growing Wal-Mart. With a forward P/E ratio of 12.09 and 5-year earnings growth projections of 12.2, we can see that it is growing almost as fast as Costco but carries a P/E ratio less than that of Wal-Mart.
Target’s current dividend yield is 2.1%, which is more than double that of Costco and 80% of the yield of Wal-Mart. As the dividend payout ratio for Target is currently only 30%, there should be a large margin of safety here, as well as the potential for increases. Given the 20.64% average annual dividend increases over the last five years, management has already proven their willingness to reward shareholders in a very fair manner. Net margins at Target over the last five years have averaged 4%, almost 10% higher than Wal-Mart and more than double those of Costco.
While Costco commands almost unheard of levels of customer loyalty within this segment of the market, it really seems to be priced for near perfect performance going forward. Management here has built a great business, but the current price point does not allow investors today to open a new position at a truly compelling price. Should the shares see a significant drop due to investor sentiment not driven by any event causing permanent impairment to the business, consideration should be given at that time. Today, it is a great business at a very high price.
Wal-Mart is the industry giant and should be expected to deliver relatively safe total returns of 9%-12% per year into the foreseeable future. Investors who buy and hold this stock will be fairly rewarded for years to come. This stock is certainly a buy, but maybe not the best one.
Target seems to be in a position where it possess the best characteristics of both Wal-Mart and Costco while avoiding the few negatives contained in their valuations. The opportunity to buy the rapid growth of Costco at the low valuations of Wal-Mart is truly the opportunity to get a discount on discount retailing.