Costco B Write-Up

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Opening new stores will increase long-term assets which is financed by long-term debt. So as we increase the long-term assets, we will subtract the long-term debt to get an increase in share-holders equity. Free cash flow is the cash available to investors and equity holders after all operating and capital expenditures such as in this case, building and opening new stores. Torres forecasted negative free cash flows at the beginning and then a steady positive increase for the years following. This makes sense because as Costco increases their investments in long-term assets, their sales will grow as well to generate positive net cash flows.

The equity method is an accounting technique used by firms to assess the profits earned by their investments in other companies. The firm reports the income earned on the investment on its income statement, and the reported value is based on the firm's share of the company assets. The reported profit is proportional to the size of the equity investment; in this case, 50%. Pro rata share of earnings from the Mexican stores were disclosed on Costco’s income statement under “interest income and other”. This would report a lower operating income and EBIT. Capital invested in these stores was listed on the balance sheet under “other assets.” It appears that she recorded this on the balance sheet as “minority interest”. These would have an effect on net income and also free cash flows. Because of this, Torres used a discount rate of 8% for her Discounted Cash Flow model instead of using the weighted average cost of capital to determine one.

When comparing Torres’ projections to that of managements’, we can infer that Torres is slightly more conservative with her projections. When looking at historical performance for sales growth in years 1997 to 2001, the average percentage growth is about 12.36%, which is 1.86% higher than what Torres projected though year 2006 and only 0.36% higher than management’s forward-looking comments. The earnings growth projection is conservative, possessing a previous average of 21.16%, with Torres’ projection being 8.06% shy of that. The ROE calculations seem to be slightly aggressive with a minimum of 14.2% between the years 1997 and 2001. At only 0.4% higher than the antecedent low point, the calculations from 2002 to 2010 proved to obtain a maximum of 14.6%. The theory of reversion to the mean correlates with Torres’ projections by showing that while there are fluctuations over the 1997 to 2010 period, the quantitative percentages average close to where they began.

At the price of $35 a share, we recommend that Torres hold her Costco shares for now. After examining Exhibit 7: Discounted Cash Flow Model, we can infer that the intrinsic value for Costco shares are about 17.35% higher than the current market value, and are continuously growing at a rate of 5% each year. If sold today, Torres would make a profit of about $6 a share. While the goal of an investor is to purchase low and sell high, the projections indicate that if we continue to hold the stock, our earning per share will increase through year 2006. After 2006, we recommend that Torres sell her stock, as earning per share will begin to decrease. By holding her shares for a few years, Torres will maximize her profits per share.