business finance project

Costco Valuation Project

FIN 4220

10/14/2021

Business Description

Costco was founded in 1976 as a wholesale retail club (Borger, 2018). It started with a distinctive annual membership model, setting it apart from the other retailers in the market, including Target and JC Penney. The company was deriving the revenues from the annual membership fees, and hence it was able to compete aggressively on the prices, which has become a competitive advantage until today. Therefore, the company provides high-quality, nationally available products and private-label merchandise at lower prices available in the market. It has more than 740 warehouses globally, selling its products online or physically in stores (Hollingshead, 2020). Costco sells its merchandise in three general categories. These are the foods category, that includes the dry, packaged, and groceries. The second section is the sundries, such as beverages and snacks. The company also sells soft lines, including apparel and small appliances. The Ancillary products include the pharmacy and gas station. The last category is the hardlines: appliances, electronics, and health (Hollingshead, 2020). The company has adopted technological developments by increasingly growing its online business. They thus provide products that are beyond those available in the warehouses through online sales. These are operations such as e-commerce, business delivery, and the travel segment.

History of Costco

The company started with the aim of serving small businesses. The company later changed into serving a selected audience to increase its market and audience . This led to the company's expansion, with a new location opened in Seattle in 1983 (Chen, 2021). The sales grew from zero to $3 billion in less than six years. The merger between Costco and Price Club in 1993 increased the number of locations for the company to 206 while generating $16 billion in annual sales (Chen, 2021). Therefore, through the operation philosophy of keeping the costs down and passing the savings to the members, the company increased its buying power. The company has further grown into a worldwide institution with total sales of $64 billion (Borger, 2018). The company has transformed the retail sector by introducing efficient buying practices that give the members increased savings. The club members derived benefits, and this increased the subscriptions. The Price Club first targeted the business members purchasing a wide range of supplies wholesale. However, it was later applied in retailing through the guidance of Jim Sinegal, bringing a change in the retail business worldwide .

Geographical Footprint and Latest News

Costco has its operations distributed in different parts of the world. Some of the countries where it operates are the United States, where the headquarters is located (Chen, 2021). The other countries are Canada, Mexico, United Kingdom, Japan, Korea, and Taiwan. It also has online operations in all the countries worldwide except in Japan, Australia, Spain, Iceland, and France (Hollingshead, 2020). According to Nasdaq, the operations in Costco were affected in September 2021 after the recall of 70,000 units of shower benches on speculations that they can collapse while in use, hence causing a hazard on the users.

Industry Overview and Competitive Positioning

Costco operates in the wholesale and retail industry. The company offers club membership to consumers, increasing the audience purchasing the products (Peterson, 2020). As a result, the company sets low prices, placing it in a better competitive position. The availability of a wide range of products under the same roof also makes it easy for consumers to acquire what they need (Chen, 2021). Therefore, the company remains competitive in the United States and other parts of the world in the wholesale industry due to low prices.

Closest Peers

Costco has several peers that compete in the same market. As a wholesale corporation using membership warehouses, the other companies try to compete with the model to enhance dominance in the market. BJ's Wholesale Club is a warehouse club that focuses on perishable goods, general merchandise, and ancillary services (Jalbert, 2019). Therefore, Costco has competitive advantages over BJ's because it offers a wider range of products. The second peer is Office Depot (Moagar-Poladian et al., 2017). It provides business services, supplies, and technological solutions to medium and small enterprises. Therefore, Costco has advantages over the company because it targets businesses and the audience. The Sam's Club is a leading membership wholesale club that offers high-quality products. It presets more competition to Costco.

Costco Porters Five Forces

Competitive Rivalry

The competition in the wholesale industry is a strong force. The company needs to counteract the effects of competition in the environment (Chen, 2021). The strong competitive rivalry against Costco is due to many firms, a high variety of firms, and low switching costs in the industry. Costco engages in both wholesale and retail business (Lenard, 2017). The retail industry is saturated, and many firms are aggressive in gaining a market share. The firms also capitalize on their unique competencies to make the competition tougher. As such, competition is among the important concerns at Costco.

Customer Bargaining Power

Customer bargaining power is a strong force. This is because the customers can easily switch to the competitors, there are many substitutes, and there is a high quality of information. The low switching costs show that the customers can acquire products from competitors, including Walmart and Amazon (Chen, 2021). The customers also have access to the internet, and, hence, they can choose and compare prices and choose the company with lower- and higher-quality products. As such, it is a major issue in the company's Five Forces Analysis.

Suppliers Bargaining Power

The supplier bargaining power is a weak force. The suppliers affect the company's business and retail environment (Johnson, 2021). However, there are a large number of suppliers from whom the company can choose from . There is also a high overall supply. As such, with many suppliers, there is no single one who can impose high prices on the supplies.

Threat of Substitutes

The company operates in the same market as the other strong competitors. Therefore, this is a strong force (Chen, 2021). Substitution is a challenge that has to be dealt with . The substitutes' low switching costs, high availability, and high performance-to-price ratio make this a strong force. The substitutes are easily accessible and hence raising the threat of substitution.

Threat of New Entrants

The new firms in the industry are a threat to the established firms. They have low switching costs, high economies of scale, and moderate business costs (Lenard, 2017). Therefore, when the consumers are assured of a great chance of success, they engage effectively with the company.

Costco SWOT Analysis

Strengths

Costco enjoys several benefits in the industry. Therefore, some of the strengths that have made it successful in the market include low prices. The low pricing strategy attracts more customers increasing the annual sales (Chen, 2021). With more sales, the profitability increases. The membership business model is unique to the company. This increases its sources of capital. Some loyal customers devote their purchases to Costco (Chen, 2021). The company does not waste money on advertising and lacks a budget for these measures. They provide high-quality products that satisfy customers.

Costco's Weaknesses

Although profitable, Costco provides a limited selection of products since, even with wide varieties, the choice for individuals is limited (Chen, 2021). The cost of transporting the goods in bulk is also high, especially when operating in the remote and suburbs. It also lacks a global presence and hence depends on few markets such as the United States.

Costco's Opportunities

Costco has opportunities in enhancing its online presence as people continue to adopt the internet. There is an opportunity for the company to expand its e-commerce for better shopping (Chen, 2021). They can also use digital advertising to reduce costs in advertising and expand to different countries to enhance competitiveness.

Costco's Threats

Costco is faced with the threat of brand reputation, where financial losses are associated with mistakes, such as product recall. Reputation in the retail business is important to remain competitive (Chen, 2021). The second threat is controversies, where problems cause the company to lose its credibility with customers. There are also political uncertainties in different countries, hence increasing costs.

Financial Analysis

Financial analysis is a system that slows provides measurements for a company's past and current financial data to establish its performance and future potential or risks. According to Nizam et al. (2019), financial analysis is used by numerous individuals such as investors, the authorities, regulatory agencies, financial analysts, among many others who depend on financial data to make essential economic decisions. Financial analysis is essential because it provides insights into the firm's relative strengths and weaknesses. According to Osina (2019), financial analysis helps provide recommendations on the actions taken by a firm to take advantage of its strengths and overcome its weaknesses in the future. The financial analysis allows evaluating the liquidity position, financial viability and profitability, and the solvency of a firm. The financial position of Costco Corporation will be examined by evaluating the financial ratios for the most current fiscal years.

Ratio Analysis

Financial ratios are the most widely used financial tools to analyze the financial position of a firm. The financial ratios of Costco Corporation are calculated from the company's financial statements and balance sheet.

Liquidity Ratios

The liquidity ratios determine the ability of a firm to meet its debt obligations for both current liabilities as they are due and long-term liabilities as they approach being current. According to Kim and Im (2017), liquidity ratios disclose the firm's cash levels and the ability to turn assets into cash to meet debt obligations. The ratios include current ratio, quick ratio, and debt to equity ratio.

Current Ratio

The current ratio is determined by dividing the current assets by the current liabilities . According to the income statement, Costco registered $23485 in current assets and $23237 in current liabilities, giving a current ratio of 1.01 (Yahoo Finance, 2021). This means that Costco has $1.01 worth of current assets for each $1.0 of current liabilities. The estimated healthy current ratios for most industries are between 1.5 and 2. This indicates that Costco is not in a good position to meet short-term obligations. Therefore, the current ratio depicts weakness, and the managers should plot steps to correct it. This may include improving conversion cycles for accounts receivable, fast payments for current liabilities, and working out unproductive assets.

Quick Ratio

The quick ratio is calculated by dividing quick assets by current liabilities. According to the income statements, Costco recorded $10979 in quick assets and $23237 current liabilities, translating to a quick ratio of 0.47 (Yahoo Finance, 2021). The quick ratio can be interpreted as $0.47 of quick assets for each $1.0 of current liabilities. This further explains that Costco is not able to pay off its current liabilities by utilizing quick assets. The recommended quick ratio should give at least 1:1 for the quick assets and the current liabilities. Purnomo (2018) asserts that a higher quick ratio ensures that the company can meet its current liabilities using its quick assets only. To improve the quick ratio, Costco management should improve sales and inventory turnover, promote invoice collections, and pay early liabilities.

Debt to Equity Ratio

The debt-to-equity ratio is calculated by dividing the total long-term debt by the total shareholder's equity. Costco recorded $5124 long-term debt and $15243 shareholder's, translating to a 0.34 debt to equity ratio (Yahoo Finance, 2021). This means that creditors provide $0.34 for each $1.0 provided by shareholders in the company's overall financing. According to Purnomo (2018), a lower debt to equity ratio shows strong financial stability. The debt-to-equity ratio is essential in determining the risk levels of a firm. Costco should maintain this low ratio for a longer period to take advantage of the financial stability.

Profitability Ratios

Profitability ratios compare the firm's financial statements to determine its ability to make profits through its operations. Several profitability ratios exist, including gross margin, returns on investment, returns on equity, and returns on assets, among others.

Gross Margin Ratio

The gross margin ratio is determined by dividing the gross profits by the revenue. Costco registered $19817 gross profits and $152703 revenue, translating to a 12.98% gross margin (Yahoo Finance, 2021). This indicates that Costco has 12.98% more after paying off its inventory, which can be used to pay for other operational costs. According to Rahman (2020), a gross margin above 30% is considered favorable. Thus, Costco should aim to improve the gross margin ratio by taking steps such as increasing product prices, avoiding competitive pricing , limiting discounts, and taking discounts from suppliers.

Return on Assets Ratio

Return on assets is obtained by dividing the net income by the average total assets. Costco registered a ROA of 8.49%, indicating that shareholders obtain 8.49% from the investment on assets (Yahoo Finance, 2021). According to Calista and Widjaja (2019), a ROA above 5% is desirable and explains the ability of the company to manage assets effectively. This shows that Costco exceeds the expectations of the industry in this case. However, the management should focus on maintaining a higher ROA to attract more investors.

Return on Equity Ratio

Return on equity is determined by dividing the net income by total shareholders' equity. The ROE ratio of Costco is 26.10%, indicating that each $1.0 invested on equity earns $0.26 annually (Yahoo Finance, 2021). A ROA of above 15% is considered desirable (Calista & Widjaja, 2019). This indicates that Costco is performing well in this ratio and should maintain it for a long period for better financial health.

Forecasting of the Free Cash Flow

The compound annual growth rate gives the average growth rate of an investment over more than one year. Using the formula; CAGR= (ending value/ beginning value) (1/no. of years)

-1, the CAGR of Costco from 2015 to 2020 is 12.16% (Yahoo Finance, 2021). This indicates that the forecast for the FCF will be increasing in future years. Free cash flow is the measure of the firm's financial performance. It is calculated by subtracting capital expenditures from the operating cash flow. FCF is essential in helping the company explore opportunities that increase shareholders' value. Therefore, the FCF for the next fiscal’s years would be calculated by the formula; FCF2021= FCF2020 (1+CAGR), which gives $3766.27 million for 2021, $4224.17 million for 2022, $4737.74 million for 2023, $5313.76 million for 2024, and $5959.80 million for 2025.

Investment Risks

Exposure to Market Risks

Costco is not adversely affected by exposure to the market like its peers, even when stocks fall below the broader S&P 500. According to Chen (2021), Costco has a strong performance and maintains robust financial stability and excellent stock market operations. The relatively strong performance is because Costco is not exposed to risky and awful business trends affecting other companies, such as Target Inc. and Kroger. Its steep premium prices depict that its stocks will take a long time to fall if the company faces challenges. The operations of Costco are less volatile than for other retailers. This is caused by the effective strategy of the company to sell products in bulk. The company also relies more on subscription sales than products markup. Subscription fees for the company keep increasing regardless of competitive selling environments (Chen, 2021). Costco prides itself on the high membership fees collected, which cushion the company when sales go down. Costco does not engage in margin competition due to its mechanism of selling memberships. This may be a good aspect for investors who have already purchased stocks. However, it may make the cost of shares to be high for new investors .

Idiosyncratic Risks

Idiosyncratic risks are investment risks that are endemic to individual assets or stocks. According to Chen et al. (2019), idiosyncratic risks account for the largest variations in uncertainties surrounding individual stocks over time than market-related risks. These factors affect the stocks of a firm at a microeconomic level and have little influence on external macroeconomic factors such as the market. Microeconomic factors associated with idiosyncratic risks include management decisions and policies, investment strategies, and specific operations that affect individual firms. Costco illustrates strong asset management and effective investment strategies, including diversification. The company does not rely on products sales for income generation like most retailers. The membership selling strategy helps to diversify the methods and strategies for the generation of revenue. This mechanism helps reduce idiosyncratic risks associated with company operations and increases effectiveness in the stock market. The company has a good corporate culture that supports employee welfare. Freeman et al. (2017) assert that Costco's turnover rate is less than half of its competitor, Sam's Club. This improves the productivity of the employees promotes sales for the company. Consequently, the performance of the company improves its stability in the stock market. By reducing idiosyncratic risks in the company, Costco can attract more investors and attain better financial capabilities.

Financial Risks

Investors are very keen on companies' financial statements because they provide essential financial information that can help make decisions on investments. According to Osina (2019), financial analysis reveals the company's financial health through analyzing various financial ratios. Depending on the outcome of the financial analysis, financial risks can be determined to ascertain the company's profitability, liquidity, and solvency. According to the financial analysis of Costco, the company depicts a strong financial capacity. For instance, Costco has a forward price-to-earnings (P/E ratio) of 36.82 (Yahoo Finance, 2021). This is higher than the industry's average of 5.29. The company registered a higher P/E ratio than its main competitor, Walmart, which registered a P/E ratio of 22.85. Costco enjoys a dividend yield of 0.84%, which is lower than Walmart’s, 1.84%. However, to complement the low dividend yields, the company has a record for consistency that can be utilized for long-term investment. The debt-to-equity ratio of Costco is 0.34. This explains that most of the company financing is from shareholders rather than creditors. A lower debt to equity ratio illustrates strong company financial stability, which sends a positive message to investors. The return on equity for Costco is 26.10% which is higher than the estimated industry average. This indicates that every $1.0 invested on equity earns $0.26. The financial issue with Costco is a low current ratio. However, this can be rectified to maintain higher financial stability and reduce the financial risks further.

Political Risks

Political stability is eminent in major Costco markets such as the United States and the Asian markets. According to Uddin et al. (2017), a firm's performance is partly dependent on the political stability of the micro and macro environments. The political stability in most of the company's market environment provides growth opportunities. It can also improve its policies and strategies to meet or exceed the expectations of different political environments. The opportunities for future growth positively attract investments. For instance, Costco developed a more accommodating animal policy that has increased the sales for animal feeds such as Dog food. Political stability in international markets has also favored Costco’s operations by providing great and peaceful markets abroad, allowing expansion and the call for more investments (Uddin et al., 2017). Investors should not this as a positive element towards purchasing Costco stock.

Legal Risks

Legal systems are responsible for imposing requirements on companies that may affect their operations and eventuality its investment attractiveness to potential investors. According to Haggard et al. (2018), laws and regulations can affect the firms' micro and macroeconomic environments, making it easier or difficult for businesses to operate. For instance, the changing employment laws in the United States indicate the minimum wage rate of $7.25 per hour. However, Costco has improved its employment practices, which exceed the requirements of the employment laws. The company increased its starting pay rate to $15.0 per hour, which is twice the minimum wage rate in the United States. Increased pay rates significantly improve workers' morale, and thus the company attains increased productivity and performance (Jardim et al., 2017). This is a good illustration to investors since increased productivity shows up in increased return on investments. Therefore, the company indicates to be a viable investment opportunity for potential investors since it shows fewer investment risks associated with it. However, investing in the company may be beneficial in the long term because it focuses on low prices and does not depend on product sales for their total revenue. Investors should also consider that the company shares may be expensive due to its performance excellence.

Corporate Governance

According to the company corporate guidelines, Costco adopts a staggered board. A staggered board is essential in ensuring that no particular board member gains majority control over the board. Hamilton James is serving as the chairperson of the board and has been a director since 1988. He was the lead independent director until he became the non-executive chairperson in 2007. Other board members include Susan Decker, who has been a director since 2004, Kenneth Denman, a director since 2007. Richard Galanti is the chief vice president, the chief financial officer, and a director in the company. He has been a director of the company since 1995 and an executive vice president and chief financial officer since 1993. Craig Jelinek is the president, the chief executive officer, and a director in the company. Jelinek has served as a director and president of the company since 2010. Sally Jewell has served in the company as a director since 2020. The director emeritus of the company since 1993 has been Richard Libeson . Other directors include Charles Munger, Jeff Raikes, John Stanton, and Maggie Wilderotter.

The majority of board members have served in the company for terms exceeding ten years. According to Bravo et al. (2017), the long-term tenure of directors may adversely harm the board's independence, with the long-serving members taking majority control of the board. However, this is the main reason the company has adopted the staggered board, which takes the popularity voting mechanism to counter the effects of the long-serving tenure of the board members. According to Mbanyele (2021), staggered boards effectively control the board's management and avoid a takeover. The method harms shareholders by restricting their rights. Shareholders would require a supermajority in voting to induce changes in the existing charters. The mechanism also bars the shareholders from taking any actions in meeting through written consent.

Costco has eleven board members, which is the normal average for large United States corporations. Four among these members are inside directors, some of whom serve in more than three boards. The corporate governance guidelines in Costco do not dive limitations on the number of boards a member should serve. However, having four busy board members may negatively harm the effectiveness of operations (Mbanyele, 2021). Costco must address the challenge of the four busy directors to streamline the effectiveness of company management, especially in decision-making strategies. The composition of the board depicts all members been whites and born in the United States. However, the policies in the company do not handle or stipulate the composition of the board members. Three board members are female, which translates to less than a quarter of the board composition. The board has no minorities, and the few female board members are still fewer. Costco should take measures to correct this because it serves many different countries with diverse customer bases. A diverse board would be more effective in managing the large and diverse customer compositions. However, the board has shown tremendous ability to manage most company issues and has continuously taken the company to larger heights.

References

Borger, M. J. (2018). Diamonds in the Rough: A Review of Tiffany v. Costco and a Call to Apply Daubert to the Admissibility of Consumer Survey Evidence in Trademark Infringement Litigation. Touro L. Rev., 34, 431.

Bravo, F., & Reguera‐Alvarado, N. (2017). The effect of board of directors on R&D intensity: board tenure and multiple directorships. R&D Management, 47(5), 701-714. https://onlinelibrary.wiley.com/doi/abs/10.1111/radm.12260

Calista, M., & Widjaja, I. (2019). Pengaruh current ratio, return on asset, return on equity, debt to equity ratio, total turnover asset, dan dividend policy terhadap harga saham. Jurnal Manajemen Bisnis Dan Kewirausahaan, 3(5), 13-18. http://journal.untar.ac.id/index.php/jmbk/article/view/6074

Chen, J. (2021). Marketing strategy management of Costco: Analysis and comparison to S-Group.

Chen, Z., & Strebulaev, I. A. (2019). Macroeconomic risk and idiosyncratic risk-taking. The Review of Financial Studies, 32(3), 1148-1187. https://academic.oup.com/rfs/article-abstract/32/3/1148/5034939

Freeman, R. E., & Parmar, B. L. (2017). Managing for Stakeholders and the Purpose of Business. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3042721

Haggard, D. L., & Haggard, K. S. (2018). The impact of law, religion, and culture on the ease of starting a business. International Journal of Organization Theory & Behavior. https://www.emerald.com/insight/content/doi/10.1108/IJOTB-04-2018-0043/full/html

Hollingshead, D. (2020). The Parasitology Unbound Collective: Commission Report. ASAP/Journal, 5(3), 715-744.

Jalbert, T. (2019). Merger Opportunities Among Club Shopping Stores. Global Journal of Business Pedagogy, 3(1), 54-65.

Jardim, E., Long, M. C., Plotnick, R., Van Inwegen, E., Vigdor, J., & Wething, H. (2017). Minimum wage increases, wages, and low-wage employment: Evidence from Seattle (No. w23532). National Bureau of Economic Research. https://www.nber.org/papers/w23532

Johnson, E. A. (2021). Costco Wholesale's Dominance in the Market.

Kim, J., & Im, C. (2017). Study on corporate social responsibility (CSR): Focus on tax avoidance and financial ratio analysis. Sustainability, 9(10), 1710. https://www.mdpi.com/226036

Lenard, M. (2017). Whole Foods Case Analysis.

Mbanyele, W. (2021). Staggered boards, unequal voting rights, poison pills and innovation intensity: New evidence from the Asian markets. International Review of Law and Economics, 65, 105970. https://www.sciencedirect.com/science/article/pii/S0144818820301836

Moagar-Poladian, S., Dumitrescu, G. C., & Tanase, I. A. (2017). Retail e-Commerce (E-tail)-evolution, characteristics and perspectives in China, the USA and Europe. Global Economic Observer, 5(1), 167.

Nizam, E., Ng, A., Dewandaru, G., Nagayev, R., & Nkoba, M. A. (2019). The impact of social and environmental sustainability on financial performance: A global analysis of the banking sector. Journal of Multinational Financial Management, 49, 35-53. https://www.sciencedirect.com/science/article/pii/S1042444X18300215

Osina, N. (2019). Global liquidity, market sentiment, and financial stability indices. Journal of Multinational Financial Management, 52, 100606. https://www.sciencedirect.com/science/article/pii/S1042444X19301872

Purnomo, A. (2018). Influence of the ratio of profit margin, financial leverage ratio, current ratio, quick ratio against the conditions and financial distress. Indonesian Journal of Business, Accounting and Management, 1(1). https://stei.ac.id/ojsstei/index.php/ijbam/article/view/218

Rahman, M. H. (2020). Financial Analysis Of Costco Wholesale Corporation: Exploring The Strengths And Weaknesses. The Bangladesh Journal of Agricultural Economics, 41(1), 17-34. http://bjae.bau.edu.bd/home/article/view/46

Uddin, M. A., Ali, M. H., & Masih, M. (2017). Political stability and growth: An application of dynamic GMM and quantile regression. Economic Modelling, 64, 610-625. https://www.sciencedirect.com/science/article/pii/S026499931730696X

Yahoo Finance. (2021). Yahoo Finance - Stock Market Live, Quotes, Business & Finance News.  https://finance.yahoo.com/quote/COST/

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