It’s generally ill-advised to attempt to try timing the market, but that doesn’t mean prospective investors should blindly buy a stock of a well-run company, either. This thought is shared by renowned investor Warren Buffett, who noted in his 1982 annual letter to Berkshire Hathaway shareholders, “For investors, paying an excessively high price for the stock of an outstanding company can negate the benefits of a decade of favorable business developments.”
With that in mind, it’s a savvy strategy for prospective investors to create a watchlist of overvalued stocks just in case they fall and become buying opportunities. And here are three stocks that fit the bill.
1. Costco Wholesale
Costco Wholesale (COST) is a membership-only retailer known as one of the best-run companies in the world. Renowned investor and Berkshire Hathaway Vice Chairman Charlie Munger recently called Costco a “perfect” company but acknowledges only one flaw: its stock valuation.
That’s because Costco shares consistently trade at a high price-to-earnings (P/E) ratio, a common valuation metric that allows for a comparison with its peers or the company’s historical average. Costco currently trades at a P/E ratio of 41, while its competitors, Target and Walmart, trade at a P/E ratio of 15 and 31, respectively. Moreover, Costco’s P/E of 41 is higher than its five-year average of 37, meaning the stock is likely priced on the high side.
Investors are consistently required to pay up for Costco for a couple of reasons, including its dividend history and flawless balance sheet.
First, Costco’s annual dividend yield of 0.69% may not look impressive, but management has consistently raised it each year since implementing it in 2004. The company also has a history of issuing a special cash dividend once every three years or so. The last special cash dividend of $10 per share was issued in December 2020, so investors could reasonably expect another one in the near future.
Second, when comparing Costco to its peers, Target and Walmart, it becomes evident that Costco’s balance sheet stands in a notably superior position. To illustrate this point, Costco boasts a net debt (total debt minus cash and cash equivalents) of negative $7.2 billion. In stark contrast, Target and Walmart report net debts of $14.4 billion and $33.4 billion, respectively. In other words, this means that Costco possesses a surplus of $7.2 billion in cash when compared to its debt, providing it with a distinct advantage in avoiding high-interest rate loans in the current market conditions — something that may not be as easily achievable for its competitors.
Overall, Costco’s stock generated a total return (stock appreciation price plus dividends) of 154% over the past five years, even with a higher valuation. Still, investors should monitor its P/E ratio in the future and try to wait for a number closer to its five-year average.
2. The Trade Desk
The next stock on this list, The Trade Desk (TTD), is a technology company known for its programmatic advertising platform that enables advertisers to effectively target and manage their online ad campaigns, particularly with connected television. Its stock has performed exceptionally well in 2023, producing a 71% gain year to date.
The Trade Desk, which partners with Walt Disney and NBC Universal, is very much still in its growth phase. The company generated $847 million in revenue during the first half of 2023, up 22% from the first half of 2022. Additionally, management guided for third-quarter 2023 revenue of at least $485 million, representing at least a 23% increase from the $395 million the company posted in Q3 2022.
Unlike many growth stocks, The Trade Desk is profitable. During the first half of 2023, the company posted a net income of $42 million, a 224% improvement from the $34 million loss during the same period in 2022. Despite the company’s revenue growth and profitability, the stock trades at an extremely high P/E ratio of 289, significantly higher than its five-year median of 155.
Beyond The Trade Desk’s stock price, investors will want to watch its rising outstanding shares. That’s because the company’s shares outstanding are up nearly 14% over the past five years, meaning if you bought a share five years ago, your ownership has been diluted by almost 14%. Now, management repurchased $337 million worth of its shares in the first half of 2023. Still, its outstanding shares are only down 0.06% because it paid nearly $231 million in stock-based compensation during that period.
Despite the high stock-based compensation — a problem management acknowledges with its recent $700 million share repurchase program — the Trade Desk is growing at a breakneck speed, so investors will have to pay a higher valuation for the foreseeable future.
The last stock on this list, Wingstop (WING), is an outlier in the restaurant industry. That’s because the chain primarily known for its chicken wings, trades at an eye-popping P/E ratio of 81, astronomically high compared to other publicly traded restaurants. For example, established fast-food chains Domino’s and McDonald’s trade at much more reasonable multiples of 29 and 25, respectively.
Beyond its market outperformance over the past five years, with a total return of 192%, the franchise-based business model is growing exponentially. In the last year, Wingstop expanded its network by 188 franchise restaurants, bringing the total to 2,046, marking a notable 10% growth. The company’s ambitious long-term goal is to reach 7,000 global restaurants, signifying a potential 242% increase from its current count.
Additionally, Wingstop claims it is on its way to delivering an impressive 19-year streak of same-store sales growth with year-over-year growth of 16.8% in domestic same-store sales for its most recent quarter (this essential metric for restaurant stocks indicates how well existing stores are performing). Wingstop’s chicken sandwich, introduced in August 2022, was a significant factor in the jump as the company taps into the 2.8 billion chicken sandwiches served annually in the U.S. For comparison, competing franchise-model fast-food restaurants Domino’s and McDonald’s had same-store sales increases in the U.S. of 0.1% and 10.3%, respectively, for their most recently reported quarters.
Wingstop is a dividend-paying stock, and management recently raised its dividend from $0.19 to $0.22 per share of common stock. Like Costco, Wingstop frequently pays a special cash dividend to its shareholders, with five distributions since becoming public in 2015. The most recent special dividend was disbursed in April 2022, amounting to $4 per share.
For prospective investors, it’s clear why Wingstop stock is the rare restaurant stock priced like a growth stock. Still, management will need to hit lofty goals to make owning the stock a smart investment at its current valuation.
Are these stocks worth buying?
There’s a fine line between waiting for a stock to drop and missing out on life-changing returns due to perennially high valuations of solid companies. One strategy to overcome decision paralysis is dollar-cost-averaging, in which an investor builds a position over time to get a range of prices for the stock instead of risking the investment on a single price.
No matter your mindset, these three stocks, while priced at a premium, are entrenched leaders in their respective industries. That makes them worth adding to your watchlist or portfolio based on risk tolerance.
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