Prediction: Ulta Beauty Stock Will Beat the Market. Here's Why.

For investors looking to beat the market, there's no need to become an expert in complex subjects such as artificial intelligence, quantum computing, or biotechnology. Simple ideas can produce market-beating stocks too, including cosmetics retailer Ulta Beauty (NASDAQ: ULTA).

Ulta Beauty is a U.S. cosmetics retailer with 1,437 stores as of the end of its fiscal third quarter of 2024. It sells hundreds of beauty brands in store, on its website, and through shop-in-shop partnerships such as its partnership with Target. And given that cosmetic products go back to the time of the Pharaohs, I don't think that they're going out of style in my lifetime.

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I believe that Ulta Beauty's brick-and-mortar presence and digital offering are both relevant for consumers. With its physical stores, many people enjoy services that can't be replaced online, such as its full-service hair salons. That said, customers these days do make a lot of online purchases. Ulta Beauty attracts shoppers to its website and app through its loyalty program, which has over 44 million members.

In fact, a high percentage of Ulta Beauty's sales come from its loyalty-membership program -- a program that grew another 5% year over year in Q3. Therefore, not only is the cosmetics industry resilient, I believe the company's own market share is resilient as well, due to its loyal members.

As a final underappreciated component of the business, Ulta Beauty's growth in digital channels is unlocking a new opportunity. Like Walmart, the company is doing more with retail media -- using digital platforms to market products to consumers, generating revenue from advertisers.

Why Ulta Beauty stock will beat the market

The foundation of my investment thesis with Ulta Beauty is that its business won't lose ground -- the thesis doesn't require a robust growth rate. Given its dominant market position, I believe this is reasonable. The company hopes to report net sales of over $11 billion for 2024, and I think its sales will be at least this high for the foreseeable future.

Ulta Beauty has respectable profitability as well. For 2024, it expects an operating margin of about 13%, and management is guiding for long-term operating margins in the range of 12.7% to 13%. There's nothing unreasonable about this guidance. In fact, this margin guidance is within the company's 10-year average, as the chart below shows.

ULTA Operating Margin (TTM) data by YCharts.

Assuming Ulta Beauty can maintain $11 billion in annual sales and achieve a 13% operating margin, the company is looking at over $1.4 billion in annual operating income.

What will Ulta Beauty do with all that money? The company doesn't have any long-term debt, so there aren't any lenders to satisfy. It also isn't opening many new stores because it's already so big. This means that future capital expenditures aren't likely to be substantial.

In my opinion, much of Ulta Beauty's profits will be returned to shareholders. The company doesn't pay a dividend, which means that it will continue doing stock buybacks as it has in the past. In fact, the chart below shows that the outstanding share count is down nearly 18% in the last five years, which is good.

ULTA Average Diluted Shares Outstanding (Quarterly) data by YCharts.

The kicker here is that Ulta Beauty is an attractive value stock. The average price-to-earnings (P/E) ratio of the S&P 500 is about 29, according to YCharts. For its part, Ulta Beauty has averaged a P/E ratio of 31 over the last 10 years. But it currently trades at a P/E ratio of just 16 -- more than 40% cheaper than the average for the stock market.

In my view, there are two possibilities here. One possibility is that Ulta Beauty stock is undervalued today, and it will eventually rise to become more fairly valued. That would be a good outcome. But I believe the more likely possibility is that it will stay in value-stock territory.

This is actually advantageous for Ulta Beauty's shareholders. If the company primarily uses cash for stock buybacks, then a cheaper stock price allows repurchases to boost shareholder value by a greater amount. In short, it's possible that the company can reduce its share count at a faster rate than in times past.

With the scenario I've laid out, I think that Ulta Beauty stock can approach a 10% annual return. But remember, this scenario implies zero growth. Assuming it can grow, the upside is higher. And it can indeed grow. In fact, its retail media network provides a simple path to higher-margin revenue growth, which can provide a boost.

I predict that Ulta Beauty stock will outperform the S&P 500 over the next five years -- and investors don't have to assume outsized risk for the upside opportunity.

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Jon Quast has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Target, Ulta Beauty, and Walmart. The Motley Fool has a disclosure policy.