Note:
Growth rate forecast
The growth rate is among the most challenging number to calculate financial valuation. Because you always have something to base on when calculating the company’s debt, option value, cost of debt, and capital. In contrast, the growth rate is most related to the future. In addition, some startups or losing money companies do not even have historical rates.
But I always estimate the growth rate first before I calculate the cost of capital for two reasons:
1. I like to finish hard work first.
2. The cost of capital can keep changing as the debt balance, stock price, and market risk premium change while you estimate the growth rate for the long term. If you value the cost of capital first, chances are you have to recalculate after you took a while to calculate the growth rate.
Investment banks, private equity, and other institutions usually have the following ways to calculate growth rate, but each method has its issues:
Figure 32
Institutional ways to calculate the growth rate.
In addition, analysts and investment banks usually are good at forecasting earnings per share for the next quarter or next year. In contrast to free cash flow in this analysis, the earning per share is net income after operating expense, interest expense, and tax, but it will not take items such as capital expenditure or acquisition into account. But these are major investments the company made for future growth.
Mechanical issues
Another issue happens when the company has had negative growth rates (decreasing revenue/income) for the last several years but a positive growth rate this year.
For example, if the company had a great year and made $50 million this year but lost $20 million in the last year. How do you calculate the growth rate?
Common Sense Issues
If you have the opportunity to work in the equity research or rating field in an institution, you will be assigned to work in a specific field. For example, if you work in the natural resource sector, you will spend your entire career following 20-30 companies such as Cheverton, ExxonMobil, Vale, and Glencore. You will focus on the sector so much that you ignore the overall economy.
Conflict of interests
If you work in investment banks, you are likely to rate companies which your bank may have merge and acquisition deals with them. It would be hard for you to recommend a company sell if it has a significant deal pending with your bank. The ratio of sell ratings to buy or hold ratings is about 1:9 among institutions. In other words, it is hard for institutions to give sell ratings unless things in that company are going to be very bad.
Fundamental growth rate forecast To estimate the fundamental growth rate, let me first explain with an example. Suppose a company invested 100 million dollars in capital and generated 15 million returns yearly. If the company does not reinvest additional capital, the return rate and the growth rate are as follows:
Figure 33
Growth Rate Example 1
Now the same company generates 15 million dollars in return, but it reinvests 3 million of that 15 million and generates the same return.
The return rate and growth rate are as follows:
Figure 34
Growth Rate Example 2
But some companies like Amazon, Facebook, and Google can achieve higher returns on capital with new investments. Now suppose the same company reinvests the same 3 million of earnings, but it generates a 20% return from new reinvestment.
The growth rate now increases from 3% to 4%.
Figure 35
Growth Rate Example 3
Takeaway:
So, the growth rate is driven by:
How much the company put back its earnings to its company-reinvestment rate.
And
How well the company makes use of its capital-return on capital.
If you take a financial class, you will learn a ratio similar to these concepts called the retention ratio.
In the college financial class, the retention ratio=
College finance education argues this is the portion of earnings that keeps in the firm to grow business in contrast to paying out.
But this formula has the following limitations:
1. The ratio has a limit between 0-100%. In other words, the most reinvestment the company can make is 100% of the net income, and the lowest is no reinvestment.
But, in reality, the company can borrow money or raise new equity, pushing the reinvestment higher than 100%.
2. Some companies, such as matured or declining companies, tend to leave considerable amounts of cash on balance without reinvesting.
3. This formula fails to capture investments such as R&D or acquisitions, which are major chunks of technology or pharmaceutical companies.
In contrast, we can incorporate all of these investments with the fundamental growth rate formula. For example, if the company had 1.5 million net income last year but spent 2.1 million in investment, the reinvestment rate is 140%.
Aligning growth rate calculation with the business model
When using the fundamental growth rate formula, it is essential to analyze the reinvestment and return on capital based on the company’s business model.
Traditional accounting regards fixed asset investments such as factory and equipment as the major investment and calls them capital expenditure because most businesses during the old time were manufacturing companies.
However, many growing companies today have spent major investments in other places with few fixed assets involved. So, when you analyze a company, you need first to know its business model and how they generate sales so that you know what its major investments are.
For example, the major investment for Nike or Adidas should be advertisement and marketing because people buy their shoes due to the brand name or sports stars in their commercials rather than what new design of their shoes.
For companies like investment banks or consulting companies, the investment to train analysts and consultants should be the major investment since they are the persons who make investment decisions. (Although the first step for many companies like Morgan Stanly to hire is an AI-powered video question interview, how they filter out candidates are things like facial expressions, gestures, and word choices. But bad investments are still investments).
For companies like Uber or Door dash, the coupon and discounts given to new users are one of the major investments.
Costco’s growth rate calculation
Warehouse Growth
Based on Costco’s business model, the major investment the company made is to build new warehouses. As a wholesale company, it has little need to invest in things like R&D, and its global brand name makes it require few marketing efforts. We can say without exaggeration that whenever Costco opens a new warehouse in a country or region, it can instantly attract many customers.
Figure 36 shows that the company has also been clear in its annual report that the major investment is to build new warehouses.
Figure 36
Costco Capital Expenditure
So, forecasting Costco’s growth rate distills down to the following questions:
How many warehouses does Costco expect to open each year in the future?
How many incremental sales can Costco achieve in each warehouse each year?
I first tried to get some clues from the company history to check two things:
How proportional is the new warehouse count to the sales?
(Will Costco open much more warehouses when there is a revenue surprise?)
Will the company largely reduce new warehouses to open during the recession?)
As you can see from Figure 37, Costco has consistently opened new warehouses, even during the 2008 financial crisis and covid, but it does decrease the number of new warehouses opened. Figure 37 shows that Costco opened seven more warehouses after 2020, so I set the new warehouse growth count for the next two years as 7. So we expect Costco to open 27 warehouses in 2022, then 34 in 2023, and 41 in 2024. But after three years, I expect Costco to keep opening new warehouses but at a decreasing rate.
From Figure 37, you can see that the median number of new warehouses before 2000 is 17.5, while after 2000 is 21. I separate the growth rate from 2000 because every company has its business cycle. The cycle comprises start-growth-high growth-mature-decline. When they were just founded, they started to grow but slower than the growth phase. So, I set the time before 2000 as a growth period while after 2000 as a high growth period. The company was founded in 1983, but the oldest number I can find is from 1994.
Then you may wonder how I know how many warehouses Costco will open after 2023. No one knows but we still can make predictions.
I first expect Costco to open 21 warehouses (the median growth rate after 2000) in 2032, and from 2035 to 2032, I use (current year warehouse-21)/ (2032-2026) and get result 4.So, if Costco decreases new warehouse GROWTH by four warehouses yearly, it will open 21 warehouses (historical average) in 2031 and 17 warehouses (growth rate before 2000) in 2032. After 2032, I expect the company to be close to maturity and grow close to the average GDP growth rate.
Figure 37
Warehouse Opened to date and expectation (in 2022 Sep)
Figure 38 shows expected new warehouses, capital expenditure, and incremental sales.
Appendix
Many people who read through this will wonder how I am sure how many warehouses Costco will open. The answer is that I am not sure. No one can be sure about the future. But the good thing is that Costco will open more or fewer warehouses in a specific year than our prediction, but the power of discount makes the differences non-material.
Figure 38
Costco growth rate forecast (in 2022 Sep)
Growth rate revision in April 2023
When I revised the valuation, I found that Costco opened 26 warehouses in 2022, only one warehouse different from my expectation.
However, according to the company’s most recent quarterly report on February 12, 2023, it only opened 11 warehouses for the first three months of the fiscal year. But I think that is mainly due to the overall business environment. So many issues, such as inflation and the Russian war, may affect management decisions.
So, I expect the company to open another 20 warehouses and total of 31 warehouses trailing 12 months (TTM). Figure 39 shows new expected new warehouses, incremental capital expenditure, and net sales revenue growth.
In Figure 38, we calculated projected capital expenditure and incremental sales (how much more additional net sales revenues compared with that of last year) based on the new warehouse opened. Then we calculate the total net sales for each year in the future by adding sales last year with the incremental sales.
Figure 39
Costco growth rate forecast (in 2023 April)
Membership Growth
As Figure 38 shows, Costco’s revenue comprises net sales and membership fees.
Compared with product sales in the warehouse, membership requires much less cost, so that has a different profit margin. So, we need to forecast the product sales and membership revenues separately. As you can see from Figure 39, I calculated the median membership fee growth rate and membership fees per warehouse.
Membership fee Forecast 2023 Revision
However, when I valued the stock in 2022, I just added median membership per warehouse*total projected warehouse, underestimating the membership price growth.
The median membership fee per warehouse growth rate is about 4%. I think the number makes sense as the long-term inflation rate in the U.S and Canada (the primary business regions of Costco) is 2%, and Costco has the seller power to charge a higher growth rate than inflation.
This is why companies like Amazon, Microsoft, and Tesla stock still grow during 2023.
In the past, I was only concerned more about the macroeconomic situation, expecting sales to decline due to inflation and recession. But many giant companies, including Costco, have the selling power to increase the price but still maintain sales due to their market share and specialty. If you check the Costco membership history, it generally grows 5 dollars every five years. So, let us give the company that credit.
Figure 40
Costco projected growth with increasing membership price.
As Figure 40 shows, I expect the membership revenue to continue to grow at around 10% and gradually decrease to 6%. During your analysis, sometimes you will worry about if you give the company too optimistic growth as well. But you can always check with common sense. If you see the Costco membership revenue growth from 2013-2022, you can tell that the forecast is not too optimistic.
Free Cash Flow
Operating Margin and EBIT (Operating income)
After we estimate future sales revenues, we need to forecast how much operating income (profits) the company can get from sales revenues.
As we mentioned before, the merchandise sales and membership will have different percentages of operating expenses as of sales revenue.
But estimating the profit margin separately for Costco is difficult because the warehouse usually has a customer service place to handle membership questions. From the financial statement, we cannot differentiate how much of SG&A cost is for the membership and how much is for sales.
So, when I value the company for the first time, I use the total operating income/sales revenue to calculate the operating margin.
Figure 41
Costco Operating Margin in 2022
Costco Operating Margin in 2023
Figure 42
Costco FCF analysis in 2022
However, as you can see from Figure 44, Costco’s operating expense consists of merchandise costs and SG&A cost, and later I found that part of stock compensation for employees is in the SG&A expense. So, if we use the 3.19% percentage operating margin, we will not effectively incorporate our forecast on future SG&A.
(The preopening expense refers to the expense the company spent on the new warehouse opening, and I think they are operating expenses rather than capital expenditures. We will explain that later.)
As shown in Figure 43, the merchandise grows proportionally with sale revenues, but the SG&A cost does not.
Figure 43
Cost Merchandise, SG&A cost as percentages of revenues and growth rates.
Figure 44
Costco income statement in 2022 10k
In Figure 45, I first calculated the operating income with the profit margin method. (Sale revenue*median profit margin 3.19% in Figure 41).
Then I calculated again with the following formula
Projected Sale Revenue*(1-median % of merchandise cost-median % of SG&A-median % of preopening expenses). And I called it the Detailed expense method.
The results are pretty different, and the SG&A is the primary reason since all other numbers are the same or close.
Figure 45
FCF with profit margin method vs detailed expense method
Some accountants and analysts encountering similar situations will use the 3.19% profit margin, claiming they are conservative. But just comparing the future earnings of the profit margin method in Figure 45 to the company the previous earning in Figure 42, you can find that if they use the 3.19% profit margin, they will unconsciously assume that the company will stop growing from now on since the earnings will be similar to that of 2020-2023. This is why I keep stressing that common sense is especially important in financial analysis, while many professionals have lost it.
Stock compensations in SG&A
Stock compensation are options the company pays or rewards employees and gives employees the right to buy the company stock at a specific price (called exercise price).
There are two main reasons why companies issue stock compensations:
Many young technology companies pay employees stock options because they don’t have enough cash from earnings at the early stage. By doing so, the company gives out a piece of the company. So, when the company has positive cash flow in the future, these employees will take away some future cash flow which otherwise will go to equity investors like you and me.
Stock compensations were not common until 1990 when legislation tried limiting corporations’ executive salaries. The politicians are so good at blaming CEO’s payment since it is easier to understand the voters by saying, “the average CEO gets paid xx times as average employees”. And as a result, companies started to give stock compensation. The result is that the CEO still can get similar pay, but society pays more for the accountants, and valuing stock price becomes messier.
Employees usually will not exercise the option until the company stock’s market price exceeds the exercise price. By issuing employee stock options, the company pays the employees part of the future cash flow.
But if we subtract a percentage of revenue from future flow as stock compensation, we will overestimate the expense since the employees do not exercise options yearly. In addition, when employees buy the company’s stock at exercise, they will also bring about cash to the company, although the price/share is lower than the market price.
The accountant adds options to the total shares outstanding to get diluted earning/share, claiming that they are being consistent.
But doing so ignores the additional cash that will bring in when employees exercise their options.
Analysts add employee options to the company's total shares and exercise price*total options to the company’s equity.
But such actions will assume employees exercise all options today, ignoring the time effect and overvaluing the company stock price.
Information about Costco’s stock option-talk with the right people in analysis
When I value Costco’s stock for the first time, I don’t know how to estimate how many stock options it will give in the future. So, I went to a Costco warehouse near my house and got acquainted with the people working there. Then I asked those warehouse store managers how many stock options they could get. I plan to get to know how many options managers can get and estimate the total by checking how many managers are in each warehouse.
But Costco warehouse managers told me that they are not senior enough positions to receive stock compensation.
I am glad I at least got some information, and I thought if I can know how many corporate employees (versus warehouse) Costco have and how much they get paid, I may estimate the stock options. But I am unable to get that information after trying.
Surprisingly, I found the following information from Costco’s stock incentive plan.
Figure 46
Costco's stock compensation plan
From the above information, I learned that Costco employees cannot get stock options until they have worked for the company for 25 years, and from employee reviews, I know that most frontline employees will not make a high enough salary to receive stock options.
So as long as I can calculate the total market value of stock options on balance today, I don’t need to worry about future stock options since I don’t think I will hold them company for over 25 years.
Although I didn’t get much information from Costco employees directly, I am unlikely to find them before talking with their employees. So, when you value a company, you should always listen to different voices and hang out with people who disagree with you. Listening to a company’s financial managers, equity analysts, and investment bankers will limit your horizon and give you biased information.
Attention:
Things will be very different for young or technology companies since many pay a large part of employees’ salaries as stock options. That’s why many employees in silly valley fell into debt after they lost their jobs in 2022. But the stock option is a double-edged sword. On the other hand, they can also scale up employees’ wealth much faster than earning salaries.
Fundamental analysis of stock compensation
So, I decided first to calculate the SG&A excluded stock compensation as a percentage of revenue and calculate how much percentage of revenues goes to stock compensation less tax benefit. (The company enjoys tax benefits when issuing stock compensation, so we subtract that benefit from stock compensation to get the company’s net expense on stock compensation).
Then calculate the value of stock options today and forecast possible future options.
Then subtract the company's PV of total future cash flow from the total value of options.
Attention:
After subtracting the PV of total options from the FCF, we don’t need to add options to total shares anymore. Adding shares now will double counting the option expense.
Figure 47
Costco stock compensations (exclude RSU)
From page 56 of each year’s Costco’s 10k, we can get the total stock compensation expense and tax benefit.
The company’s accountants also show details such as total shares granted, exercised, and weighted average exercise price.
Then we divide net stock compensation expense by annual revenue to get how many percents of revenues are stock compensation. And I found that the company only pays about 0.19% of revenue to stock compensation and calculated adjusted FCF in Figure 48.
We will deal with RSU (restricted stock the unit at the end of this analysis)
Figure 48
Future stock compensation adjusted FCF
Attention:
Costco has few stocks compensation because it has been founded for a while and due to its business nature. Young or technology companies can have large stock compensation when they have few or negative earnings. Do not underestimate the effect of stock compensations.
Preopening Expense
Before discussing Costco’s preopening expense, I want to explain another important concept in Finance or life-Sunk Cost.
Imagine an airline company just invested money to set up a new line from the US to Russia in December 2021, and now they lost almost all their investment due to the invasion. Now the company is working on new lines in other countries like Germany or France, do they need to consider the loss in Russia in their future growth plan?
Many financial and project managers will unintentionally consider loss in Russia for the future, but the fact is that the failure in Russia has occurred and cannot be recovered. And that failure should not affect future business decisions. The cost that happened in Russia is called sunk cost.
When I valued Costco’s stock in 2022, I found the following information on p27 of 2021 10K.
Figure 49
Preopening expense
And my first reaction is that preopening is a capital expenditure, which is the money spent today expecting to generate revenues for many years.
However, I later realized that Costco needs to pay it whenever it opens new warehouses, regardless of how well that new warehouse is doing or if they close the warehouse. So, the preopening expense is a sunk cost.
And since Costco always open new warehouses, I just estimated preopening expense and included that in the operating expense forecast in FCF.
Net Change of Working Capital
The NOWC (Net Change of Working Capital) is the current assets and liabilities a business must maintain to run the day-to-day business. For example, a convenience store needs to maintain more inventory than they usually sell in case of stockout and maintain some cash for daily transactions. Some stores will have short-term liabilities. For example, many will buy inventory first while paying at the end of the month or until the product is sold. Traditional accounting defines the NOWC as current assets less current liabilities, claiming that they will reduce the company's free cash flow, so analysts should subtract them when doing valuation. However, how accountants define current assets and liabilities in NOWC distorts the company's actual cash position.
Finance subtracts NOWC from FCF because increasing current assets, such as inventories, will reduce the free cash flow while increasing current liabilities, such as short-term debt or accounts payable, will increase the free cash flow.
Figure 50
Costco's 2023 10k annual report
Take Costco's 2023 10k annual report, we can find that the current assets include:
Cash and cash equivalents
Short-term investments
Receivables
Merchandise Inventories
Other Current Assets.
If the account's standpoint is that the NOWC will hurt the company's free cash flow, then we should not include the cash balance and short-term investment. (The former are usually short-term, low-risk investments with high liquidity such as US treasury bonds). In fact, the feckless action to include cash in NOWC can easily underestimate a company's free cash flow and value. Many analysts mispriced Apple stock in 2018-2019 because they subtracted over $60-70 billion in cash and short-term investment from free cash flow.
On the other hand, the current liabilities include:
Accounts Payable
Accrued salaries and benefits
Account member rewards
Deferred membership fees
Current-portion of long-term debt
Other Current Liabilities.
Many items look confusing, but it is ok since those are accounting rather than human language.
Account payable means the company bought inventory, for example, but hasn't paid.
Accrued salaries and benefits are employees' payments they have earned, but the company hasn't paid.
Accrued member rewards mean the 2% cash back the Costco member will receive, but the company hasn't paid.
Deferred membership fees-in accounting logic, the company does not earn the revenue until they deliver the product or service.
But in human commonsense, we know that at the moment the customer pays or renews the membership, Costco has collected the cash and can use it to buy products or invest in opening new warehouses, regardless of whether the customer shops once a week or a month.
We may need to consider the membership refund cost since Costco guarantees unconditional membership refunds. But from the 10k, I learned that the renewal rate for the membership is over 91% so I don't need to worry about that much. I also have the in-person experience before I value the stock. Costco Canada failed to deliver my reward check three times, but I still feel it is hard to cancel the membership because I need 2 pounds of steak daily. Although I believe my personal case is not so much a matter of Costco's service as a matter of Canada's working ethics.
Current portion of long-term debt
Accounting rule defines debt with one year or less maturity as short-term debt while over one-year as long-term. Since we calculate the market value of debt while calculating the cost of debt, including them in the NOWC will double count the risk, and we will subtract them from the current liability.
Other current liabilities
Based on my observation, the word “Other" is one of the accountant's favorite words, and we will spend more time figuring that out later.
As a result, an adjusted formula for NOWC should be (Non-cash current asset) - (Non-debt current liabilities).
Figure 51
Adjusted Costco NOWC calculated Sep 2022
(Non-cash current asset=total current asset-cash balance-short term investment)
(Non-debt current liability=total current liability-short term debt or short-term part of long-term debt)
As the Table shows, Costco has a negative NOWC, which means they usually buy products on credit on a much larger scale than how much its customers owe them on credit. For example, they may buy 10k kilos of chicken to sell first and pay the supplier later, while some long-term local store clients may buy 500 kilos each from Costco and pay at the end of the month. As a result, Costco will have a much larger account payable than its account receivable so that has negative NOWC.
If a person graduates from a university like the Ohio State University, he will feel confused now since all he has learned from the college about NOWC is subtracting NOWC from FCF since they are reducing free cash flow, and all projects he has done will have a positive NOWC.
If the person graduated from NYU, he might set the negative to zero for FCF, claiming that a company cannot take significant credit forever. And that is true for many companies. A young technology might have negative NOWC when it grows, but after ten years, the company may have matured and cannot take significant credit since its suppliers are unsure if they can make enough sales to pay off the credit on time.
If the person graduated from universities like the University Canada West, he may not know what NOWC is.
But how about Costco? My first reaction is that Costco should be able to maintain negative NOWC over time since it is a giant customer for suppliers, and its suppliers cannot say no to it easily. If you took an accounting class in the last century or a finance class in UCW now, you will learn that accountants used the current ratio (current asset/current liability) to evaluate the company's risk and said the current ratio is larger or equal to 2 is good. But later there was a company came and said why 2? Why not 1? Why not sell the product first and pay later? That company is called Walmart.
Walmart has been there for over 160 years, but I checked their 10k Form, and they still have negative NOWC.
But I still decided to take a look at the breakdown of Costco's current assets and liabilities to see whether they are sustainable. When evaluating these items, remember that our goal is to see whether they will affect future free cash flow, which requires my judgment.
As I mentioned, Costco bought products from suppliers but hasn't paid yet. I believe Costco can do that as long as possible due to its size and purchasing power.
Accrued Salaries and Benefits: These refer to salaries and benefits that employees have earned but will receive payment later. For example, suppose an employee receives a paycheck on the 25th of each month, while the accountants prepare the financial statement on the 30th or 31st. In that case, they will record 5 or 6 days of accused salaries since employees have worked but aren't paid for these parts until the next pay period. Costco can do that as long as possible, and that will not hurt the company's free cash flow.
However, these items include not only salaries but other items such as insurance benefits. For benefits like health insurance, the company usually accumulates.
For health insurance, we can expect that as the older the company is, the more likely the employees will use that benefit. In other words, Costco can still get positive cash flow by carrying healthcare liability but there is a point in time that it cannot since employees started to withdraw benefits, and the company will have few new employees as it is matured.
So, I first calculate how much percent of NOWC comes from insurance and then subtract that part from NOWC of terminal years.
As the figure is shown below,
The stock price decreased by about 130 dollars per share after I did that. You can also subtract that part from 2023-2032, but if you try, you will find that there are little differences.
Figure 52
Insurance adjusted FCF
But the Accrued Salary and benefit will include other benefits, and I will try to figure it other later.
Other current liabilities
I can not find any detailed information about these items in the most recent annual report, but after reading several previous 10k, I found the accountant does provide a breakdown for Costco's 2016 10k.
Figure 53
Costco Other current liabilities
Looking over these items, I believe that the only items that we cannot expect Costco to maintain forever are insurance-related liabilities. Because companies usually pay insurance for employees during their growth, but as it matures and employees get older, the company will reduce headcounts. Employees will gradually start to take insurance benefits.
So the solution is to calculate the many percentages of NOWC from the insurance-related liabilities and exclude that from the company's terminal year NOWC.However, just when I am about to feel relief, I found the following information from the company's 10k.
Figure 54
Costco insurance liabilities
In other words, part of the insurance liabilities is reported in "Accrued Salary and Benefit" and part in the "Other current liabilities," the accountant did not tell you how much is in the accused salary and benefit.
Figure 55
% of current liabilities
To solve that problem, I first add up Accrued salaries and Other current liabilities, then calculate how many percents of NOWC are from accrued salaries and Other current liabilities, then calculate how many percents of Insurance are in accrued salaries and Other current liabilities, then multiply these two number to get how much percentage of total non-debt is from insurance/self-insurance liabilities.
Then we can play with some numbers!
As you can see from the table below, the median non-cash current debt is about 66.28% of non-debt current liabilities. So
NOWC=66% of non-debt current liabilities minus 100%non-debt current liabilities
=-33.72 % non-debt current liabilities.
Figure 56
Insurance liabilities adjusted FCF
FCF before Adjusted NOWC
FCF after Adjusted NOWC for Insurance/Self-insurance liabilities
Then we use the NOWC% of sales revenue to calculate the estimated terminal year NOWC,
then we can get estimated non-debt current liabilities for the terminal year by dividing that number by -33.72 % and get $47574.39 million.
Then multiply the result by 5.428% (insurance/non-debt current liabilities) to get the estimated insurance liabilities for the terminal year.
And since we think the company have fewer new insurance liabilities as it matures, we add the amount to the NOWC at the terminal year (because the terminal NOWC is a negative number). This adjustment decreased the stock price by about $500.
Attention:
For terminal year NOWC, you will use original NOWC + Projected Insurance liabilities.
Since the NOWC =non-cash current asset minus non-debt current liabilities,
while the FCF formula subtracts NOWC, a decrease in liabilities will increase NOWC and decrease FCF.
Additional adjustments
So far, we have removed insurance liabilities. We don't think that is sustainable and explained that accrued salary should be sustainable, but how about other accrued benefits? The accountants record accrued salary and benefits and partly explain insurance. But what else is in the accrued benefits? My research shows that Costco employees' benefit includes 401k, PTO, and sick leaves. Then we need to analyze if the accrued benefit included these benefits and make estimations and adjustments. For example, if the accrued benefit includes 401k, we should add it back to NOWC to subtract from the FCF since the company cannot use it elsewhere, even if some of them are not legal obligations. But The P48 of company 10k mentioned that the 401k costs are mainly in the SG&A cost. In addition, the accountants didn't give us any information about other benefit amounts, how much are accrued salaries and how much are benefits. Of course, a lazy solution will be subtracting the percentage of total accrued salary and benefit, but that will underestimate the stock price if the accrued salary is a large portion of the accrued salary and benefit.
Accrued Salary Estimation
As I mentioned before, the accrued salaries are part of the salary the company hasn’t paid by the reporting date while the employee has finished the work. So, if accountants finish financial statements on August 31 while the employee usually gets paid on August 25, then 6 days of salary is accrued salary. I don’t think this will hurt the company's free cash flow since they should be able to do it all the time.
Figure 57
Costco positions
I first tried to see how many kinds of positions were in each warehouse and how much they earned. Then I can estimate their salaries by estimating how many of them are in each warehouse and multiplying by the total. But the issue with this option is that it is hard to estimate how many employees there are in one warehouse for some positions such as meat cutter. In addition, I am unsure if there are other positions and how many employees there are on the corporate site, such as marketing, financial, operation managers, IT technician, etc. These people usually earn a much higher salary but have much fewer headcounts than employees in the warehouse.
With limited information, I decided to use the SG&A expense on the income statement to estimate the total salary and total accrued salary. The SG&A refers to selling, general and administrative expenses and are overhead costs to maintain business operations. Examples of SG&A are administrative materials, rent, utilities, supplies, software and technology costs, human resources, and administrative salaries. I think most of the company’s SG&A cost will be administrative salaries. Due to its business model, I expect it to spend few on other SG&A such as administrative materials, software, and technology costs, and it should be able to enjoy low rent and utilities due to its size. So I expect 80% of S&GA will be salary.
Figure 45
Simulated Accrual Salary table
I learned from the internet that Costco employees receive biweekly pay, while Costco’s 10k shows the reporting date is usually around the end of August. So I did a simulation to see how many days would count as accrued salaries when the accountants filed financial statements. Since the accountants accrued salaries in the last pay period will be paid in the next pay period, only the salary between August 26 and the end of August will be accrued.
With the ratio in Figure 45 and projected salaries revenue in 2032, we can estimate ending year NOWC and SG&A. Notice that I calculated the stock compensation excluding SG&A since the accountants included the stock compensation in the SG&A in the company’s 10k income statement. However, the employees usually will not exercise stock options unless the price exceeds the strike price. So, we will estimate them separately.
Figure 59
% of stock compensation
With these ratios, we can estimate how much SG&A in the ending year, how much the accrued salaries, how much total accrued salaries and benefits, and how much of them are accrued benefits with the following formula:Estimated sales revenue at 2032 * SG&A % Excluded stock
compensations *80% / 12 months/ 30 days * 5 days accrual.
Figure 60
Costco estimated accrued benefit
Figure 60 shows that we estimated $365.75 million in accrued salaries in 2032, $7127.77 total accrued salaries and benefits, and $6762.02 million in accrued benefits. When I added back the accrued benefit to the ending year NOWC in 2032, I got a new stock price of $1081,96 per share.
Figure 61
FCF with adjusted NOWC
When I do the analysis, I calculate FCF, first, calculate NOWC then consider the stock compensation in Figure 59. After we adjusted NOWC and stock compensation, the current stock price is as follows:
Figure 62
Costco stock price after stock compensation adjusted
RSU and acquisitions
Congratulations! Now you are at the last step of this analysis.
RSU (restricted stock unit)
When I discussed employee stock options, I mentioned that the company gives up some future cash flow to employees because employees can buy stock at an exercise price when the market price goes high. But RSU is different from those stock options since it usually has a time limit to exercise. For Costco’s RSU, an employee can only start exercising after working for Costco for 25 years and only exercise 1/5 each year after 25 years. The illiquidity of RSU reduces its value since employees cannot exercise before the 25-year benchmark even if the stock price jumps to a historical high. I also searched reviews from employee websites such as Glassdoor and Indeed, and most employees said that they are very unlikely to exercise the stock option or they don’t earn high enough to make the stock option worth it.
Figure 51 shows the total amount of Costco’s RSU over time, and you can find that it keeps reducing, implicating that employees rarely get or get very few new RSUs in a short time.
Figure 63
Costco RSU overtime
Therefore, we will only reduce the discount value of RSU from today. When you value RSU and estimate how much discount the RSU has compared to the market price, you can just use the following formula to get the stock price.
There are other complicated ways to calculate RSU, such as the regression model, but we will just use this formula now since Costco’s RSU is not significant.
And from research and data in the following link from NYU Stern, you can tell that the average discount for RSU is about 35%.
https://pages.stern.nyu.edu/~adamodar/New_Home_Page/valquestions/illiquiddisc.htm
From the most p13 of the most recent Costco 10Q form released on June 1st, the company still has 3.074 million RSU, and from Yahoo Finance, it has 443.15 million total outstanding shares.
So, the Value per share=
Acquisition
Acquisitions are actions when a company buys another company. According to McKinsey and Harvard business school, over 70-90% of acquisitions end up losing money. Of course, when we see losing money, we may see the parent company and its equity holders. Investment banks and private equity usually end up earning money from deals.
It is crucial to value the market value of an acquisition to see how much the company loses. If you value a company with many acquisitions, you must see how they fund them. Calculating the value of the debt or stock options is necessary if the company takes debt or gives shares when they acquire another company. Then you compare with market value of the acquisition and total money spent to see how much money the parent company loses or gains and add that to the company’s FCF model.
Challenges in value acquisition
The biggest challenge to value acquisition is that many targets are private companies with no public information, and some M&A deals do not disclose how much the parent company pay. I am valuing Oracle recently, a database management company with about 180 acquisitions, with 80% being undisclosed.
It seems too hard to value private companies, but now common sense has come into play again. Imagine a new pizza restaurant just opened in your neighborhood. Are you able to estimate how much revenue they have each month if you have never dined there?
You can estimate since this is not the only pizza place you have been to, and you can have a ballpark of how much each pizza is, how many pizzas they can sell, and how much they pay salaries.
So, there is always a way to value.
You will find a more detailed process in my Oracle stock valuation in the future, but now let us value Costco’s acquisition.
2020 Innovel Solutions
In 2020, Costco acquired Innovel, a logistic company that provides final-mile delivery, installation, and white-glove capabilities for big and bulky products in the United States and Puerto Rico.
The deal is $999 million, all in cash. The accountants record $255 in tangible, and intangible assets, $192 in liabilities, and $935 in goodwill. (Goodwill is not a real asset or liability. It is just a fancy name accountants made up when they cannot justify the extra money company spends).
Initially, I plan to see Innovel’s service and estimate its revenues with FCF cash flow. But later, I found I could not find that information, and the cost is really small compared to Costco as a whole.
So I took the shortcut. I first got the price/book value of the equity ratio from NYU Stern, which is 4.9.
Then I use (255-192)*4.9 to get $161.7 million.
Final Costco stock price
Remember, in part one, I explained that equity investors get money after everyone else(such as the suppliers, the debt holders, etc.)
So the formula below is used to calculate the stock price:
Stock price=
Figure 52
Costco stock price estimation on July 5,2023 2:32AM EST
Attention:
Don’t forget to update the government bond rate and equity risk premium.
Word at the end
You made it! Now you have gone through the process of valuing financial assets. I appreciate your patience and persistence. When I started to value companies, I never expected that I could achieve this analysis. It is all about incremental work and margins. If you want to take control of your own assets and wealth, you should start from today by valuing them and being patient. If you have any questions, feel free to comment below or my post on LinkedIn. If you are an accountant and don’t like my analysis, I really don’t care. If you want to take the analysis for job interviews, you can try, but I will caution you the analysis may not increase your chance of getting a job because they want traders and salesmen. I hope you find this analysis helpful.
Thank you.
Zachary Chen
July 5,2023 2:38AM EST
The growth rate is among the most challenging number to calculate financial valuation. Because you always have something to base on when calculating the company’s debt, option value, cost of debt, and capital. In contrast, the growth rate is most related to the future. In addition, some startups or losing money companies do not even have historical rates.
But I always estimate the growth rate first before I calculate the cost of capital for two reasons:
1. I like to finish hard work first.
2. The cost of capital can keep changing as the debt balance, stock price, and market risk premium change while you estimate the growth rate for the long term. If you value the cost of capital first, chances are you have to recalculate after you took a while to calculate the growth rate.
Investment banks, private equity, and other institutions usually have the following ways to calculate growth rate, but each method has its issues:
Figure 32
Institutional ways to calculate the growth rate.
In addition, analysts and investment banks usually are good at forecasting earnings per share for the next quarter or next year. In contrast to free cash flow in this analysis, the earning per share is net income after operating expense, interest expense, and tax, but it will not take items such as capital expenditure or acquisition into account. But these are major investments the company made for future growth.
Mechanical issues
Another issue happens when the company has had negative growth rates (decreasing revenue/income) for the last several years but a positive growth rate this year.
For example, if the company had a great year and made $50 million this year but lost $20 million in the last year. How do you calculate the growth rate?
Common Sense Issues
If you have the opportunity to work in the equity research or rating field in an institution, you will be assigned to work in a specific field. For example, if you work in the natural resource sector, you will spend your entire career following 20-30 companies such as Cheverton, ExxonMobil, Vale, and Glencore. You will focus on the sector so much that you ignore the overall economy.
Conflict of interests
If you work in investment banks, you are likely to rate companies which your bank may have merge and acquisition deals with them. It would be hard for you to recommend a company sell if it has a significant deal pending with your bank. The ratio of sell ratings to buy or hold ratings is about 1:9 among institutions. In other words, it is hard for institutions to give sell ratings unless things in that company are going to be very bad.
Fundamental growth rate forecast To estimate the fundamental growth rate, let me first explain with an example. Suppose a company invested 100 million dollars in capital and generated 15 million returns yearly. If the company does not reinvest additional capital, the return rate and the growth rate are as follows:
Figure 33
Growth Rate Example 1
Now the same company generates 15 million dollars in return, but it reinvests 3 million of that 15 million and generates the same return.
The return rate and growth rate are as follows:
Figure 34
Growth Rate Example 2
But some companies like Amazon, Facebook, and Google can achieve higher returns on capital with new investments. Now suppose the same company reinvests the same 3 million of earnings, but it generates a 20% return from new reinvestment.
The growth rate now increases from 3% to 4%.
Figure 35
Growth Rate Example 3
Takeaway:
So, the growth rate is driven by:
How much the company put back its earnings to its company-reinvestment rate.
And
How well the company makes use of its capital-return on capital.
If you take a financial class, you will learn a ratio similar to these concepts called the retention ratio.
In the college financial class, the retention ratio=
College finance education argues this is the portion of earnings that keeps in the firm to grow business in contrast to paying out.
But this formula has the following limitations:
1. The ratio has a limit between 0-100%. In other words, the most reinvestment the company can make is 100% of the net income, and the lowest is no reinvestment.
But, in reality, the company can borrow money or raise new equity, pushing the reinvestment higher than 100%.
2. Some companies, such as matured or declining companies, tend to leave considerable amounts of cash on balance without reinvesting.
3. This formula fails to capture investments such as R&D or acquisitions, which are major chunks of technology or pharmaceutical companies.
In contrast, we can incorporate all of these investments with the fundamental growth rate formula. For example, if the company had 1.5 million net income last year but spent 2.1 million in investment, the reinvestment rate is 140%.
Aligning growth rate calculation with the business model
When using the fundamental growth rate formula, it is essential to analyze the reinvestment and return on capital based on the company’s business model.
Traditional accounting regards fixed asset investments such as factory and equipment as the major investment and calls them capital expenditure because most businesses during the old time were manufacturing companies.
However, many growing companies today have spent major investments in other places with few fixed assets involved. So, when you analyze a company, you need first to know its business model and how they generate sales so that you know what its major investments are.
For example, the major investment for Nike or Adidas should be advertisement and marketing because people buy their shoes due to the brand name or sports stars in their commercials rather than what new design of their shoes.
For companies like investment banks or consulting companies, the investment to train analysts and consultants should be the major investment since they are the persons who make investment decisions. (Although the first step for many companies like Morgan Stanly to hire is an AI-powered video question interview, how they filter out candidates are things like facial expressions, gestures, and word choices. But bad investments are still investments).
For companies like Uber or Door dash, the coupon and discounts given to new users are one of the major investments.
Costco’s growth rate calculation
Warehouse Growth
Based on Costco’s business model, the major investment the company made is to build new warehouses. As a wholesale company, it has little need to invest in things like R&D, and its global brand name makes it require few marketing efforts. We can say without exaggeration that whenever Costco opens a new warehouse in a country or region, it can instantly attract many customers.
Figure 36 shows that the company has also been clear in its annual report that the major investment is to build new warehouses.
Figure 36
Costco Capital Expenditure
So, forecasting Costco’s growth rate distills down to the following questions:
How many warehouses does Costco expect to open each year in the future?
How many incremental sales can Costco achieve in each warehouse each year?
I first tried to get some clues from the company history to check two things:
How proportional is the new warehouse count to the sales?
(Will Costco open much more warehouses when there is a revenue surprise?)
Will the company largely reduce new warehouses to open during the recession?)
As you can see from Figure 37, Costco has consistently opened new warehouses, even during the 2008 financial crisis and covid, but it does decrease the number of new warehouses opened. Figure 37 shows that Costco opened seven more warehouses after 2020, so I set the new warehouse growth count for the next two years as 7. So we expect Costco to open 27 warehouses in 2022, then 34 in 2023, and 41 in 2024. But after three years, I expect Costco to keep opening new warehouses but at a decreasing rate.
From Figure 37, you can see that the median number of new warehouses before 2000 is 17.5, while after 2000 is 21. I separate the growth rate from 2000 because every company has its business cycle. The cycle comprises start-growth-high growth-mature-decline. When they were just founded, they started to grow but slower than the growth phase. So, I set the time before 2000 as a growth period while after 2000 as a high growth period. The company was founded in 1983, but the oldest number I can find is from 1994.
Then you may wonder how I know how many warehouses Costco will open after 2023. No one knows but we still can make predictions.
I first expect Costco to open 21 warehouses (the median growth rate after 2000) in 2032, and from 2035 to 2032, I use (current year warehouse-21)/ (2032-2026) and get result 4.So, if Costco decreases new warehouse GROWTH by four warehouses yearly, it will open 21 warehouses (historical average) in 2031 and 17 warehouses (growth rate before 2000) in 2032. After 2032, I expect the company to be close to maturity and grow close to the average GDP growth rate.
Figure 37
Warehouse Opened to date and expectation (in 2022 Sep)
Figure 38 shows expected new warehouses, capital expenditure, and incremental sales.
Appendix
Many people who read through this will wonder how I am sure how many warehouses Costco will open. The answer is that I am not sure. No one can be sure about the future. But the good thing is that Costco will open more or fewer warehouses in a specific year than our prediction, but the power of discount makes the differences non-material.
Figure 38
Costco growth rate forecast (in 2022 Sep)
Growth rate revision in April 2023
When I revised the valuation, I found that Costco opened 26 warehouses in 2022, only one warehouse different from my expectation.
However, according to the company’s most recent quarterly report on February 12, 2023, it only opened 11 warehouses for the first three months of the fiscal year. But I think that is mainly due to the overall business environment. So many issues, such as inflation and the Russian war, may affect management decisions.
So, I expect the company to open another 20 warehouses and total of 31 warehouses trailing 12 months (TTM). Figure 39 shows new expected new warehouses, incremental capital expenditure, and net sales revenue growth.
In Figure 38, we calculated projected capital expenditure and incremental sales (how much more additional net sales revenues compared with that of last year) based on the new warehouse opened. Then we calculate the total net sales for each year in the future by adding sales last year with the incremental sales.
Figure 39
Costco growth rate forecast (in 2023 April)
Membership Growth
As Figure 38 shows, Costco’s revenue comprises net sales and membership fees.
Compared with product sales in the warehouse, membership requires much less cost, so that has a different profit margin. So, we need to forecast the product sales and membership revenues separately. As you can see from Figure 39, I calculated the median membership fee growth rate and membership fees per warehouse.
Membership fee Forecast 2023 Revision
However, when I valued the stock in 2022, I just added median membership per warehouse*total projected warehouse, underestimating the membership price growth.
The median membership fee per warehouse growth rate is about 4%. I think the number makes sense as the long-term inflation rate in the U.S and Canada (the primary business regions of Costco) is 2%, and Costco has the seller power to charge a higher growth rate than inflation.
This is why companies like Amazon, Microsoft, and Tesla stock still grow during 2023.
In the past, I was only concerned more about the macroeconomic situation, expecting sales to decline due to inflation and recession. But many giant companies, including Costco, have the selling power to increase the price but still maintain sales due to their market share and specialty. If you check the Costco membership history, it generally grows 5 dollars every five years. So, let us give the company that credit.
Figure 40
Costco projected growth with increasing membership price.
As Figure 40 shows, I expect the membership revenue to continue to grow at around 10% and gradually decrease to 6%. During your analysis, sometimes you will worry about if you give the company too optimistic growth as well. But you can always check with common sense. If you see the Costco membership revenue growth from 2013-2022, you can tell that the forecast is not too optimistic.
Free Cash Flow
Operating Margin and EBIT (Operating income)
After we estimate future sales revenues, we need to forecast how much operating income (profits) the company can get from sales revenues.
As we mentioned before, the merchandise sales and membership will have different percentages of operating expenses as of sales revenue.
But estimating the profit margin separately for Costco is difficult because the warehouse usually has a customer service place to handle membership questions. From the financial statement, we cannot differentiate how much of SG&A cost is for the membership and how much is for sales.
So, when I value the company for the first time, I use the total operating income/sales revenue to calculate the operating margin.
Figure 41
Costco Operating Margin in 2022
Costco Operating Margin in 2023
Figure 42
Costco FCF analysis in 2022
However, as you can see from Figure 44, Costco’s operating expense consists of merchandise costs and SG&A cost, and later I found that part of stock compensation for employees is in the SG&A expense. So, if we use the 3.19% percentage operating margin, we will not effectively incorporate our forecast on future SG&A.
(The preopening expense refers to the expense the company spent on the new warehouse opening, and I think they are operating expenses rather than capital expenditures. We will explain that later.)
As shown in Figure 43, the merchandise grows proportionally with sale revenues, but the SG&A cost does not.
Figure 43
Cost Merchandise, SG&A cost as percentages of revenues and growth rates.
Figure 44
Costco income statement in 2022 10k
In Figure 45, I first calculated the operating income with the profit margin method. (Sale revenue*median profit margin 3.19% in Figure 41).
Then I calculated again with the following formula
Projected Sale Revenue*(1-median % of merchandise cost-median % of SG&A-median % of preopening expenses). And I called it the Detailed expense method.
The results are pretty different, and the SG&A is the primary reason since all other numbers are the same or close.
Figure 45
FCF with profit margin method vs detailed expense method
Some accountants and analysts encountering similar situations will use the 3.19% profit margin, claiming they are conservative. But just comparing the future earnings of the profit margin method in Figure 45 to the company the previous earning in Figure 42, you can find that if they use the 3.19% profit margin, they will unconsciously assume that the company will stop growing from now on since the earnings will be similar to that of 2020-2023. This is why I keep stressing that common sense is especially important in financial analysis, while many professionals have lost it.
Stock compensations in SG&A
Stock compensation are options the company pays or rewards employees and gives employees the right to buy the company stock at a specific price (called exercise price).
There are two main reasons why companies issue stock compensations:
Many young technology companies pay employees stock options because they don’t have enough cash from earnings at the early stage. By doing so, the company gives out a piece of the company. So, when the company has positive cash flow in the future, these employees will take away some future cash flow which otherwise will go to equity investors like you and me.
Stock compensations were not common until 1990 when legislation tried limiting corporations’ executive salaries. The politicians are so good at blaming CEO’s payment since it is easier to understand the voters by saying, “the average CEO gets paid xx times as average employees”. And as a result, companies started to give stock compensation. The result is that the CEO still can get similar pay, but society pays more for the accountants, and valuing stock price becomes messier.
Employees usually will not exercise the option until the company stock’s market price exceeds the exercise price. By issuing employee stock options, the company pays the employees part of the future cash flow.
But if we subtract a percentage of revenue from future flow as stock compensation, we will overestimate the expense since the employees do not exercise options yearly. In addition, when employees buy the company’s stock at exercise, they will also bring about cash to the company, although the price/share is lower than the market price.
The accountant adds options to the total shares outstanding to get diluted earning/share, claiming that they are being consistent.
But doing so ignores the additional cash that will bring in when employees exercise their options.
Analysts add employee options to the company's total shares and exercise price*total options to the company’s equity.
But such actions will assume employees exercise all options today, ignoring the time effect and overvaluing the company stock price.
Information about Costco’s stock option-talk with the right people in analysis
When I value Costco’s stock for the first time, I don’t know how to estimate how many stock options it will give in the future. So, I went to a Costco warehouse near my house and got acquainted with the people working there. Then I asked those warehouse store managers how many stock options they could get. I plan to get to know how many options managers can get and estimate the total by checking how many managers are in each warehouse.
But Costco warehouse managers told me that they are not senior enough positions to receive stock compensation.
I am glad I at least got some information, and I thought if I can know how many corporate employees (versus warehouse) Costco have and how much they get paid, I may estimate the stock options. But I am unable to get that information after trying.
Surprisingly, I found the following information from Costco’s stock incentive plan.
Figure 46
Costco's stock compensation plan
From the above information, I learned that Costco employees cannot get stock options until they have worked for the company for 25 years, and from employee reviews, I know that most frontline employees will not make a high enough salary to receive stock options.
So as long as I can calculate the total market value of stock options on balance today, I don’t need to worry about future stock options since I don’t think I will hold them company for over 25 years.
Although I didn’t get much information from Costco employees directly, I am unlikely to find them before talking with their employees. So, when you value a company, you should always listen to different voices and hang out with people who disagree with you. Listening to a company’s financial managers, equity analysts, and investment bankers will limit your horizon and give you biased information.
Attention:
Things will be very different for young or technology companies since many pay a large part of employees’ salaries as stock options. That’s why many employees in silly valley fell into debt after they lost their jobs in 2022. But the stock option is a double-edged sword. On the other hand, they can also scale up employees’ wealth much faster than earning salaries.
Fundamental analysis of stock compensation
So, I decided first to calculate the SG&A excluded stock compensation as a percentage of revenue and calculate how much percentage of revenues goes to stock compensation less tax benefit. (The company enjoys tax benefits when issuing stock compensation, so we subtract that benefit from stock compensation to get the company’s net expense on stock compensation).
Then calculate the value of stock options today and forecast possible future options.
Then subtract the company's PV of total future cash flow from the total value of options.
Attention:
After subtracting the PV of total options from the FCF, we don’t need to add options to total shares anymore. Adding shares now will double counting the option expense.
Figure 47
Costco stock compensations (exclude RSU)
From page 56 of each year’s Costco’s 10k, we can get the total stock compensation expense and tax benefit.
The company’s accountants also show details such as total shares granted, exercised, and weighted average exercise price.
Then we divide net stock compensation expense by annual revenue to get how many percents of revenues are stock compensation. And I found that the company only pays about 0.19% of revenue to stock compensation and calculated adjusted FCF in Figure 48.
We will deal with RSU (restricted stock the unit at the end of this analysis)
Figure 48
Future stock compensation adjusted FCF
Attention:
Costco has few stocks compensation because it has been founded for a while and due to its business nature. Young or technology companies can have large stock compensation when they have few or negative earnings. Do not underestimate the effect of stock compensations.
Preopening Expense
Before discussing Costco’s preopening expense, I want to explain another important concept in Finance or life-Sunk Cost.
Imagine an airline company just invested money to set up a new line from the US to Russia in December 2021, and now they lost almost all their investment due to the invasion. Now the company is working on new lines in other countries like Germany or France, do they need to consider the loss in Russia in their future growth plan?
Many financial and project managers will unintentionally consider loss in Russia for the future, but the fact is that the failure in Russia has occurred and cannot be recovered. And that failure should not affect future business decisions. The cost that happened in Russia is called sunk cost.
When I valued Costco’s stock in 2022, I found the following information on p27 of 2021 10K.
Figure 49
Preopening expense
And my first reaction is that preopening is a capital expenditure, which is the money spent today expecting to generate revenues for many years.
However, I later realized that Costco needs to pay it whenever it opens new warehouses, regardless of how well that new warehouse is doing or if they close the warehouse. So, the preopening expense is a sunk cost.
And since Costco always open new warehouses, I just estimated preopening expense and included that in the operating expense forecast in FCF.
Net Change of Working Capital
The NOWC (Net Change of Working Capital) is the current assets and liabilities a business must maintain to run the day-to-day business. For example, a convenience store needs to maintain more inventory than they usually sell in case of stockout and maintain some cash for daily transactions. Some stores will have short-term liabilities. For example, many will buy inventory first while paying at the end of the month or until the product is sold. Traditional accounting defines the NOWC as current assets less current liabilities, claiming that they will reduce the company's free cash flow, so analysts should subtract them when doing valuation. However, how accountants define current assets and liabilities in NOWC distorts the company's actual cash position.
Finance subtracts NOWC from FCF because increasing current assets, such as inventories, will reduce the free cash flow while increasing current liabilities, such as short-term debt or accounts payable, will increase the free cash flow.
Figure 50
Costco's 2023 10k annual report
Take Costco's 2023 10k annual report, we can find that the current assets include:
Cash and cash equivalents
Short-term investments
Receivables
Merchandise Inventories
Other Current Assets.
If the account's standpoint is that the NOWC will hurt the company's free cash flow, then we should not include the cash balance and short-term investment. (The former are usually short-term, low-risk investments with high liquidity such as US treasury bonds). In fact, the feckless action to include cash in NOWC can easily underestimate a company's free cash flow and value. Many analysts mispriced Apple stock in 2018-2019 because they subtracted over $60-70 billion in cash and short-term investment from free cash flow.
On the other hand, the current liabilities include:
Accounts Payable
Accrued salaries and benefits
Account member rewards
Deferred membership fees
Current-portion of long-term debt
Other Current Liabilities.
Many items look confusing, but it is ok since those are accounting rather than human language.
Account payable means the company bought inventory, for example, but hasn't paid.
Accrued salaries and benefits are employees' payments they have earned, but the company hasn't paid.
Accrued member rewards mean the 2% cash back the Costco member will receive, but the company hasn't paid.
Deferred membership fees-in accounting logic, the company does not earn the revenue until they deliver the product or service.
But in human commonsense, we know that at the moment the customer pays or renews the membership, Costco has collected the cash and can use it to buy products or invest in opening new warehouses, regardless of whether the customer shops once a week or a month.
We may need to consider the membership refund cost since Costco guarantees unconditional membership refunds. But from the 10k, I learned that the renewal rate for the membership is over 91% so I don't need to worry about that much. I also have the in-person experience before I value the stock. Costco Canada failed to deliver my reward check three times, but I still feel it is hard to cancel the membership because I need 2 pounds of steak daily. Although I believe my personal case is not so much a matter of Costco's service as a matter of Canada's working ethics.
Current portion of long-term debt
Accounting rule defines debt with one year or less maturity as short-term debt while over one-year as long-term. Since we calculate the market value of debt while calculating the cost of debt, including them in the NOWC will double count the risk, and we will subtract them from the current liability.
Other current liabilities
Based on my observation, the word “Other" is one of the accountant's favorite words, and we will spend more time figuring that out later.
As a result, an adjusted formula for NOWC should be (Non-cash current asset) - (Non-debt current liabilities).
Figure 51
Adjusted Costco NOWC calculated Sep 2022
(Non-cash current asset=total current asset-cash balance-short term investment)
(Non-debt current liability=total current liability-short term debt or short-term part of long-term debt)
As the Table shows, Costco has a negative NOWC, which means they usually buy products on credit on a much larger scale than how much its customers owe them on credit. For example, they may buy 10k kilos of chicken to sell first and pay the supplier later, while some long-term local store clients may buy 500 kilos each from Costco and pay at the end of the month. As a result, Costco will have a much larger account payable than its account receivable so that has negative NOWC.
If a person graduates from a university like the Ohio State University, he will feel confused now since all he has learned from the college about NOWC is subtracting NOWC from FCF since they are reducing free cash flow, and all projects he has done will have a positive NOWC.
If the person graduated from NYU, he might set the negative to zero for FCF, claiming that a company cannot take significant credit forever. And that is true for many companies. A young technology might have negative NOWC when it grows, but after ten years, the company may have matured and cannot take significant credit since its suppliers are unsure if they can make enough sales to pay off the credit on time.
If the person graduated from universities like the University Canada West, he may not know what NOWC is.
But how about Costco? My first reaction is that Costco should be able to maintain negative NOWC over time since it is a giant customer for suppliers, and its suppliers cannot say no to it easily. If you took an accounting class in the last century or a finance class in UCW now, you will learn that accountants used the current ratio (current asset/current liability) to evaluate the company's risk and said the current ratio is larger or equal to 2 is good. But later there was a company came and said why 2? Why not 1? Why not sell the product first and pay later? That company is called Walmart.
Walmart has been there for over 160 years, but I checked their 10k Form, and they still have negative NOWC.
But I still decided to take a look at the breakdown of Costco's current assets and liabilities to see whether they are sustainable. When evaluating these items, remember that our goal is to see whether they will affect future free cash flow, which requires my judgment.
As I mentioned, Costco bought products from suppliers but hasn't paid yet. I believe Costco can do that as long as possible due to its size and purchasing power.
Accrued Salaries and Benefits: These refer to salaries and benefits that employees have earned but will receive payment later. For example, suppose an employee receives a paycheck on the 25th of each month, while the accountants prepare the financial statement on the 30th or 31st. In that case, they will record 5 or 6 days of accused salaries since employees have worked but aren't paid for these parts until the next pay period. Costco can do that as long as possible, and that will not hurt the company's free cash flow.
However, these items include not only salaries but other items such as insurance benefits. For benefits like health insurance, the company usually accumulates.
For health insurance, we can expect that as the older the company is, the more likely the employees will use that benefit. In other words, Costco can still get positive cash flow by carrying healthcare liability but there is a point in time that it cannot since employees started to withdraw benefits, and the company will have few new employees as it is matured.
So, I first calculate how much percent of NOWC comes from insurance and then subtract that part from NOWC of terminal years.
As the figure is shown below,
The stock price decreased by about 130 dollars per share after I did that. You can also subtract that part from 2023-2032, but if you try, you will find that there are little differences.
Figure 52
Insurance adjusted FCF
But the Accrued Salary and benefit will include other benefits, and I will try to figure it other later.
Other current liabilities
I can not find any detailed information about these items in the most recent annual report, but after reading several previous 10k, I found the accountant does provide a breakdown for Costco's 2016 10k.
Figure 53
Costco Other current liabilities
Looking over these items, I believe that the only items that we cannot expect Costco to maintain forever are insurance-related liabilities. Because companies usually pay insurance for employees during their growth, but as it matures and employees get older, the company will reduce headcounts. Employees will gradually start to take insurance benefits.
So the solution is to calculate the many percentages of NOWC from the insurance-related liabilities and exclude that from the company's terminal year NOWC.However, just when I am about to feel relief, I found the following information from the company's 10k.
Figure 54
Costco insurance liabilities
In other words, part of the insurance liabilities is reported in "Accrued Salary and Benefit" and part in the "Other current liabilities," the accountant did not tell you how much is in the accused salary and benefit.
Figure 55
% of current liabilities
To solve that problem, I first add up Accrued salaries and Other current liabilities, then calculate how many percents of NOWC are from accrued salaries and Other current liabilities, then calculate how many percents of Insurance are in accrued salaries and Other current liabilities, then multiply these two number to get how much percentage of total non-debt is from insurance/self-insurance liabilities.
Then we can play with some numbers!
As you can see from the table below, the median non-cash current debt is about 66.28% of non-debt current liabilities. So
NOWC=66% of non-debt current liabilities minus 100%non-debt current liabilities
=-33.72 % non-debt current liabilities.
Figure 56
Insurance liabilities adjusted FCF
FCF before Adjusted NOWC
FCF after Adjusted NOWC for Insurance/Self-insurance liabilities
Then we use the NOWC% of sales revenue to calculate the estimated terminal year NOWC,
then we can get estimated non-debt current liabilities for the terminal year by dividing that number by -33.72 % and get $47574.39 million.
Then multiply the result by 5.428% (insurance/non-debt current liabilities) to get the estimated insurance liabilities for the terminal year.
And since we think the company have fewer new insurance liabilities as it matures, we add the amount to the NOWC at the terminal year (because the terminal NOWC is a negative number). This adjustment decreased the stock price by about $500.
Attention:
For terminal year NOWC, you will use original NOWC + Projected Insurance liabilities.
Since the NOWC =non-cash current asset minus non-debt current liabilities,
while the FCF formula subtracts NOWC, a decrease in liabilities will increase NOWC and decrease FCF.
Additional adjustments
So far, we have removed insurance liabilities. We don't think that is sustainable and explained that accrued salary should be sustainable, but how about other accrued benefits? The accountants record accrued salary and benefits and partly explain insurance. But what else is in the accrued benefits? My research shows that Costco employees' benefit includes 401k, PTO, and sick leaves. Then we need to analyze if the accrued benefit included these benefits and make estimations and adjustments. For example, if the accrued benefit includes 401k, we should add it back to NOWC to subtract from the FCF since the company cannot use it elsewhere, even if some of them are not legal obligations. But The P48 of company 10k mentioned that the 401k costs are mainly in the SG&A cost. In addition, the accountants didn't give us any information about other benefit amounts, how much are accrued salaries and how much are benefits. Of course, a lazy solution will be subtracting the percentage of total accrued salary and benefit, but that will underestimate the stock price if the accrued salary is a large portion of the accrued salary and benefit.
Accrued Salary Estimation
As I mentioned before, the accrued salaries are part of the salary the company hasn’t paid by the reporting date while the employee has finished the work. So, if accountants finish financial statements on August 31 while the employee usually gets paid on August 25, then 6 days of salary is accrued salary. I don’t think this will hurt the company's free cash flow since they should be able to do it all the time.
Figure 57
Costco positions
I first tried to see how many kinds of positions were in each warehouse and how much they earned. Then I can estimate their salaries by estimating how many of them are in each warehouse and multiplying by the total. But the issue with this option is that it is hard to estimate how many employees there are in one warehouse for some positions such as meat cutter. In addition, I am unsure if there are other positions and how many employees there are on the corporate site, such as marketing, financial, operation managers, IT technician, etc. These people usually earn a much higher salary but have much fewer headcounts than employees in the warehouse.
With limited information, I decided to use the SG&A expense on the income statement to estimate the total salary and total accrued salary. The SG&A refers to selling, general and administrative expenses and are overhead costs to maintain business operations. Examples of SG&A are administrative materials, rent, utilities, supplies, software and technology costs, human resources, and administrative salaries. I think most of the company’s SG&A cost will be administrative salaries. Due to its business model, I expect it to spend few on other SG&A such as administrative materials, software, and technology costs, and it should be able to enjoy low rent and utilities due to its size. So I expect 80% of S&GA will be salary.
Figure 45
Simulated Accrual Salary table
I learned from the internet that Costco employees receive biweekly pay, while Costco’s 10k shows the reporting date is usually around the end of August. So I did a simulation to see how many days would count as accrued salaries when the accountants filed financial statements. Since the accountants accrued salaries in the last pay period will be paid in the next pay period, only the salary between August 26 and the end of August will be accrued.
With the ratio in Figure 45 and projected salaries revenue in 2032, we can estimate ending year NOWC and SG&A. Notice that I calculated the stock compensation excluding SG&A since the accountants included the stock compensation in the SG&A in the company’s 10k income statement. However, the employees usually will not exercise stock options unless the price exceeds the strike price. So, we will estimate them separately.
Figure 59
% of stock compensation
With these ratios, we can estimate how much SG&A in the ending year, how much the accrued salaries, how much total accrued salaries and benefits, and how much of them are accrued benefits with the following formula:
Estimated sales revenue at 2032 * SG&A % Excluded stock compensations *80% / 12 months/ 30 days * 5 days accrual.
Figure 60
Costco estimated accrued benefit
Figure 60 shows that we estimated $365.75 million in accrued salaries in 2032, $7127.77 total accrued salaries and benefits, and $6762.02 million in accrued benefits. When I added back the accrued benefit to the ending year NOWC in 2032, I got a new stock price of $1081,96 per share.
Figure 61
FCF with adjusted NOWC
When I do the analysis, I calculate FCF, first, calculate NOWC then consider the stock compensation in Figure 59. After we adjusted NOWC and stock compensation, the current stock price is as follows:
Figure 62
Costco stock price after stock compensation adjusted
RSU and acquisitions
Congratulations! Now you are at the last step of this analysis.
RSU (restricted stock unit)
When I discussed employee stock options, I mentioned that the company gives up some future cash flow to employees because employees can buy stock at an exercise price when the market price goes high. But RSU is different from those stock options since it usually has a time limit to exercise. For Costco’s RSU, an employee can only start exercising after working for Costco for 25 years and only exercise 1/5 each year after 25 years. The illiquidity of RSU reduces its value since employees cannot exercise before the 25-year benchmark even if the stock price jumps to a historical high. I also searched reviews from employee websites such as Glassdoor and Indeed, and most employees said that they are very unlikely to exercise the stock option or they don’t earn high enough to make the stock option worth it.
Figure 51 shows the total amount of Costco’s RSU over time, and you can find that it keeps reducing, implicating that employees rarely get or get very few new RSUs in a short time.
Figure 63
Costco RSU overtime
Therefore, we will only reduce the discount value of RSU from today. When you value RSU and estimate how much discount the RSU has compared to the market price, you can just use the following formula to get the stock price.
There are other complicated ways to calculate RSU, such as the regression model, but we will just use this formula now since Costco’s RSU is not significant.
And from research and data in the following link from NYU Stern, you can tell that the average discount for RSU is about 35%.
https://pages.stern.nyu.edu/~adamodar/New_Home_Page/valquestions/illiquiddisc.htm
From the most p13 of the most recent Costco 10Q form released on June 1st, the company still has 3.074 million RSU, and from Yahoo Finance, it has 443.15 million total outstanding shares.
So, the Value per share=
Acquisition
Acquisitions are actions when a company buys another company. According to McKinsey and Harvard business school, over 70-90% of acquisitions end up losing money. Of course, when we see losing money, we may see the parent company and its equity holders. Investment banks and private equity usually end up earning money from deals.
It is crucial to value the market value of an acquisition to see how much the company loses. If you value a company with many acquisitions, you must see how they fund them. Calculating the value of the debt or stock options is necessary if the company takes debt or gives shares when they acquire another company. Then you compare with market value of the acquisition and total money spent to see how much money the parent company loses or gains and add that to the company’s FCF model.
Challenges in value acquisition
The biggest challenge to value acquisition is that many targets are private companies with no public information, and some M&A deals do not disclose how much the parent company pay. I am valuing Oracle recently, a database management company with about 180 acquisitions, with 80% being undisclosed.
It seems too hard to value private companies, but now common sense has come into play again. Imagine a new pizza restaurant just opened in your neighborhood. Are you able to estimate how much revenue they have each month if you have never dined there?
You can estimate since this is not the only pizza place you have been to, and you can have a ballpark of how much each pizza is, how many pizzas they can sell, and how much they pay salaries.
So, there is always a way to value.
You will find a more detailed process in my Oracle stock valuation in the future, but now let us value Costco’s acquisition.
2020 Innovel Solutions
In 2020, Costco acquired Innovel, a logistic company that provides final-mile delivery, installation, and white-glove capabilities for big and bulky products in the United States and Puerto Rico.
The deal is $999 million, all in cash. The accountants record $255 in tangible, and intangible assets, $192 in liabilities, and $935 in goodwill. (Goodwill is not a real asset or liability. It is just a fancy name accountants made up when they cannot justify the extra money company spends).
Initially, I plan to see Innovel’s service and estimate its revenues with FCF cash flow. But later, I found I could not find that information, and the cost is really small compared to Costco as a whole.
So I took the shortcut. I first got the price/book value of the equity ratio from NYU Stern, which is 4.9.
Then I use (255-192)*4.9 to get $161.7 million.
Final Costco stock price
Remember, in part one, I explained that equity investors get money after everyone else(such as the suppliers, the debt holders, etc.)
So the formula below is used to calculate the stock price:
Stock price=
Figure 52
Costco stock price estimation on July 5,2023 2:32AM EST
Attention:
Don’t forget to update the government bond rate and equity risk premium.
Word at the end
You made it! Now you have gone through the process of valuing financial assets. I appreciate your patience and persistence. When I started to value companies, I never expected that I could achieve this analysis. It is all about incremental work and margins. If you want to take control of your own assets and wealth, you should start from today by valuing them and being patient. If you have any questions, feel free to comment below or my post on LinkedIn. If you are an accountant and don’t like my analysis, I really don’t care. If you want to take the analysis for job interviews, you can try, but I will caution you the analysis may not increase your chance of getting a job because they want traders and salesmen. I hope you find this analysis helpful.
Thank you.
Zachary Chen
July 5,2023 2:38AM EST
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