I was once one of those Costco (NASDAQ:COST) skeptics, thinking that the richly valued shares of a thin-margin, big-box retailer deserved to trade lower. I couldn't justify a stock that was valued at 32x current-year earnings (back in 2017, but shares are worth much more today), despite solid financial results and a strong balance sheet.

• Warning! GuruFocus has detected 2 Warning Sign with COST.

I turned bullish on the company and the stock once I finally saw the light, in 2018. Over the past five years, Costco has been up an impressive 213% on relatively low volatility against the S&P 500's 84% gains. Most recently, around this time last year, I explained that Costco could be worth $500 billion in market capitalization using very optimistic assumptions (more on this below).

Despite lots of skepticism from my readers back then, Costco's share price shot up another 39% in the past year to nearly reach my best-case-scenario market cap target. But therein lies the problem: at an equity value of around $450 billion today, I can no longer comfortably remain a Costco bull, as valuation has run well ahead of what I could consider reasonable.

Why Costco is so valuable

I believe that Costco is still largely a misunderstood stock. Shares trade today at a 2025 EPS multiple of 55x, which many find absurdly high given a 2026 earnings growth estimate of only 11% implying a stratospheric PEG of 5.0x and last year's dismal GAAP operating margin of 3.6%. How could this be?

What many potential investors don't seem to fully grasp is that net earnings-based valuations are heavily influenced by two factors: EPS growth, which most analysts rarely fail to scrutinize, but also risk, which I think is often overlooked. The lower the risk that a company will achieve the expected financial results in the future, the higher the valuation tends to be. And this is where Costco shines brightly.

The retailer runs a rare brick-and-mortar subscription business model. To get inside a Costco store, shoppers need to pay an annual fee that ranges from $60 (Gold Star) to $120 (Executive) in the US. I estimate that virtually all the money collected from Costco's members flows straight down to the company's operating profit line, which helps to explain why membership dollars account for only 2% of total revenues, but more than 55% of total operating income.

Household Costco membership has risen recently at a pace of 8% per year, at a staggering renewal rate of 93%, which underscores Costco's brand loyalty and value perception among consumers.

In other words, modest revenue growth of around 10% and op margins of less than 4% are not what investors pay the most attention to when valuing COST. The recurring-revenue model and the very low risk that profits will ever disappoint (see chart below and notice the minimal volatility in Costco's operating income over time) are what really matter.

DCF used to support bullishness, but no more

My super-bullish case that supported a market cap of $500 billion was backed by a simple DCF (discounted cash flow) analysis that I performed on Costco's membership fees. Worth noting, I think that the entirety of the company's $250 billion-per-year retail operation only serves one purpose: to convince shoppers to pay Costco the $60 or $120 annual membership fee. In my view, selling rotisserie chicken at $5, hot dogs at $1, or a 27-pound tub of mac and cheese for less than $100 does not create any value to shareholders.

To justify the optimistic target of $500 billion in market cap, I started with the $4.6 billion collected in membership fees in fiscal 2023. I then assumed that this figure would grow at a rate of 5% in perpetuity that's right, forever, until the sun turns into a red giant and melts all those oversized mac and cheese containers that Costco sold to its customers over the years.

Due to world-class brand recognition and stellar renewal rates, I believe that such membership fee projections are low risk. For this reason, discounting all future fees to present value using a discount rate of 6% would be aggressive, but plausible keep in mind that the 10-year risk-free rate is currently 4.4%.

Armed with these three figures ($4.6 billion in fees, 5% perpetuity growth, and 6% discount rate), I could apply the following formula to arrive at Costco's fair (but quite optimistic) equity value of roughly $500 billion.

I understand that defending a stock price increase of around 45% this time last year was a very bold move. However, COST now sits only $50 billion short of my best-case price target, which suggests 10% upside at best.

Yes, a recession seems to be taking shape, and the Issaquah-based big-box retailer tends to fare well when consumers turn a bit more cost-conscious. Also, in the case of economic deceleration without the oversized threat of inflation, the risk-free rate could fall from the current 4.4% levels, which may help to support higher equity valuations.

Still, the risk-reward dynamic in this case does not seem enticing enough, in my view, to support the bullish case on the stock of this high-quality company.

Gurus who own COST

As I turn decisively more bearish on Costco, I should point out that a few big-ticket investors with a much better track record than mine continue to own shares of the retailer. Notably, Ken Fisher (Trades, Portfolio) and his Fisher Investments hold the equivalent of $2.8 billion in Costco stock, as of the fund's most recent filing.

On the less bullish side of the discussion, Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway no longer owns Costco stock. The company held shares in its portfolio over many years through 2020, but it liquidated the entire position roughly five years ago. Interestingly, some of my favorite investment gurus, including Stan Druckenmiller and Bill Ackman (Trades, Portfolio), do not have significant positions in Costco.

This article first appeared on GuruFocus.