Tesla's Over Inflated Valuation

Oct.15.13 | About: Tesla Motors (TSLA)

General Introduction

In the following paragraphs I will attempt to explain why Tesla (NASDAQ:TSLA) is over valued and over hyped.

Investors Put More Emphasis On Price

During bubbles, investors tend to believe that normal valuation metrics do not apply and that a paradigm shift has occurred. The philosophy here is that it's worth buying if someone is willing to pay more than you did. The bullish thesis for Tesla clearly revolves around said philosophy. It is nearly impossible to justify Tesla's current valuation unless you use a price-to-earnings ratio higher than that of a typical growth company.

To give you an example, let's run through a valuation calculation for Tesla. The company is expecting to sell 70,000 Model S' by the end of 2014 if Asia sales replicate American and European sales. During bubbles companies tend to over-state and under-perform. Nevertheless, let's give Tesla the benefit of the doubt, and say that it sells 70,000 Model S' annually by 2014. Let's assume that the average unit price is $80,000, the net profit margin is 10% (generous assumption) and that the tax rate is 35%. Putting those numbers together, you get $365 million in net income (which is substantial growth over FY 2013 net income). Let's give Tesla a P/E ratio of 40, and you get a valuation of only $14.6 billion (a far cry from its current valuation of $20 billion). To buy Tesla at its current market valuation means you are throwing away all common sense and naively believing that someone will pay more than you did through a higher P/E.

Capital Intensive Business Model

For the company to grow, it must build factories, "super-charging" stations, and service centers to service the cars. Remember, this is all before a single car is ever sold.

The following are quotes taken directly from Elon Musk in his quarterly shareholder's letter:

R&D expenses are expected to increase significantly in Q3 as we accelerate product development efforts on Model X, Model S right hand drive, and localization of Model S for international markets. SG&A expenses will also rise, driven by the growth in our retail locations, service centers and Supercharger facilities

We expect to spend about $150 million in the second half of this year on capital expenditures, including the recent purchase of 31 acres of land adjacent to our factory for future expansion

Generally capital intensive businesses make bad investments, especially ones that offer a high priced item. Before said company can generate a profit, it has to pay a large upfront cost. As the business grows so do the costs needed to support the growth. However, when sales decline, the company will have no way to cover its CAPEX and will be forced into bankruptcy. To put it in layman's terms, it's similar to buying parts to sell a computer, and hoping that people buy your computers so you can buy a new batch of parts and make more computers. But, instead of a computer you have an expensive item like a car that may or may not sell well.

"Strong" Balance Sheet

To support the capital intensive nature of the business, Tesla has to raise capital from either debt or investors to keep the business alive and "healthy."

According to Elon Musk, the company's financial position and balance sheet have "never been stronger".

With our recent $1 billion capital raise and subsequent repayment of the $440 million outstanding loan from the Department of Energy, our cash balance grew to almost $750 million during the quarter. Our financial position and balance sheet have never been stronger.

The preceding statement is quite ironic. One would not expect that a business with a strong balance sheet would require a $1 billion capital raise (10x previous quarter's equity). In addition, if you were to raise 10x equity out of thin air - through stock sales - your financial health would most certainly seem impeccable even though it isn't.

Furthermore, the company may not receive adequate funding needed to support the business in the future if investors are not confident in the company's ongoing operations. Therefore it is paramount that Tesla keep investor optimism up.

We cannot be certain that additional funds will be available to us on favorable terms when required, or at all.

How To Truly Value Tesla

Tesla's sales have been growing at an impressive rate; however, it is matched with unimpressive operating expenses growth - due to the capital intensive nature of the business. As a result, Tesla consistently creates dismal profits for shareholders.

Tesla has a low ROE of 3%, making it one of the least profitable companies and one of the slowest growing companies in terms of shareholder equity growth through ROE. In addition, annual return on investment (based on its current $20 billion market cap) is 0.05%. Furthermore, if you adjust return on investment (as in price paid per share) to the market average, you get a valuation for Tesla in the $10 range.

Companies that trade at high premiums should generate significant returns to investors to justify the premium paid; Tesla does not. Therefore, Tesla's high stock price is not fueled by large growth but by large optimism.

Conclusion

Tesla is not the high-flying company that many believe it to be, and is over priced no matter how you look at it. Valuation should not be dependent on optimism but by hard evidence of growth through profits and not pocket books.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.