Why does the seller of a house usually value that property more than the potential buyer? Why does the seller of a car envision a higher price than the buyer? In most transactions why does the owner believe that his possession is worth more money than the buyer is willing to pay? In behavioral finance, this phenomenon is called the "endowment effect." Simply put, the endowment effect says that once we own something, we begin to value it more than other people do.
The endowment effect most likely arose in our evolutionary past, where giving things up, even when an apparently fair exchange seemed to be on offer, was just too risky. These days, however, there are contracts, rights, and other ways of enforcing bargains. Animal societies have none of these mechanisms. As Adam Smith observed in the Wealth of Nations, "nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog."
Many times the endowment effect is caused by emotional attachment. For example, all of us have useless objects that clutter our homes. Our emotional attachment to these objects can make it difficult to throw them out or give them away, even if we do not really need them. On the other hand, it is easy to go through someone else's belongings and point out all the unnecessary junk.
The endowment effect has also been observed among investors in the stock market. Even experienced investors often become emotionally attached to certain stocks, which can cause overvaluation. One of the best examples of this, and the topic of this article, is Tesla Motors (NASDAQ:TSLA).
Tesla is a huge success story and makes beautiful cars, but the value of the company at $30 billion is entirely inflated, in my opinion. It simply never makes sense to pay over 14x trailing 12-month revenue for a company that operates in an industry characterized by low profit margins and high fixed costs. In reality, even if Tesla quadrupled its revenue to $8 billion and achieved an EBIT margin of 10% (twice the industry average), the stock would still be trading at 37x EBIT based on the current price. In other words, even if Tesla is able to achieve triple-digit growth and above average profitability, the stock would still be overpriced.
So why do Tesla investors value the stock more than any rational buyer would be willing to pay for it? I believe the endowment effect provides the best explanation. Ownership of something - whether it is a house, car, jewelry, or stock - simply changes our perspective. We somehow expect the buyer of our house, for instance, to share our feelings, emotions, and memories. Unfortunately, the buyer of your house is more likely to care about the strip of black mold in the corner. It is just difficult to see that the person on the other side of the transaction, buyer or seller, is not seeing the world as we see it.
Just like in the house example above, the buyers of Tesla shares have a different perspective than the owners. The large majority of Tesla shareholders bought the stock at a time when the whole company was valued at less than $5 billion (which was in early 2013 before the 500+% run-up). This was a rational investment decision, given the company was experiencing tremendous growth and would likely grow into this valuation within a short period of time. However, once they already owned the stock, their perspective changed.
Over time, just like the owners of a house, these once rational investors let their emotions get the better of them. They fell in love with the Tesla success story, driving the stock higher and higher. Valuation no longer mattered because in their minds Tesla was special and it would always be worth more than the current price. And in fact, the stock continued to rise even after the company's own CEO said it was overvalued. But after more than a six-fold increase in the price of the stock in less than two years, the valuation no longer makes sense. By this point, however, Tesla investors have become blind to this fact because they have fallen victim to the endowment effect.
Apart from the stock being ridiculously overvalued, there is still another risk that Tesla investors have ignored. Tesla operates in one of the most competitive and capital-intensive industries in the world. In fact, manufacturing cars is such a tough business that 99.99% of car makers end up going bankrupt. The United States, for instance, has seen hundreds of car makers come and go during the last century. Only the "big three" - Ford (NYSE:F), General Motors (NYSE:GM), and Chrysler - survive today. But even out of the three that were lucky enough to survive, two went bankrupt and had to be bailed out. Given this high failure rate, Tesla's odds of long-term success are extremely low indeed.
There is an old saying, "A horse that can count to ten is a remarkable horse, not a remarkable mathematician." Likewise, a well-managed car company revolutionizing the transportation industry is a remarkable car company, but not a remarkable business. The truth of the matter is that Tesla will always be a hugely capital-intensive business just a few bad quarters away from bankruptcy. Sadly, many investors will learn this lesson the hard way it seems.
In short, although Tesla is among the best and most innovative car companies in the world, the stock is outrageously overpriced and is a terrible long-term investment. Moreover, the company operates in a high fixed cost and highly competitive industry that has on the whole made negative returns for its investors. My suggestion to those who want to participate in the Tesla electric car revolution without taking on huge financial risk - sell the stock and buy the car instead.
Disclosure: The author is short TSLA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.