Under What Assumptions Is Tesla Trading At Fair Value?

Aug.26.14 | About: Tesla Motors (TSLA)

Summary

Tesla's market cap is at over $30 billion, although it has reported net losses over the last twelve months.

It is estimated that Tesla will sell 35k cars in this fiscal year, estimated earnings are $1.08 per share.

With two upcoming models and battery production at the Gigafactory, there are huge growth opportunities.

Overview

The Silicon Valley based car manufacturer Tesla Motors (NASDAQ:TSLA) has a market capitalization of $32 billion and reports sales (TTM) of $2.5 billion and net losses of $170 million.

Since Tesla hasn't even sold 50,000 cars in its lifetime and expects just 35,000 cars to be sold in this fiscal year, yet has a market capitalization pretty similar to the one of premium car manufacturer Audi (which expects revenues to be in excess of $65 billion this fiscal year), it is obvious that a lot of expectations for future growth are already priced into Tesla's stock.

Using discounted cash flows, I will try to evaluate under which assumptions the stock is undervalued, trades at fair value or is overvalued respectively, and then try to assess which of these scenarios are the most likely.

Discounted cash flow method

The DCF method is a model to assess the value of an investment by discounting all future cash flows (with a desired return rate) to their present value and adding up those present values of future earnings. In order to do so we have to make a couple of assumptions and simplifications:

- As a starting point for EPS, I will use the consensus estimate for next fiscal year, $3.33.

- I will calculate with a discount factor of 10%, meaning buying the company at the estimated fair value would give an investor an average annual return of 10% on his investment.

- In all scenarios, I will use a relatively high growth rate in the first couple of years and a comparatively low growth rate after that, a common characteristic of growing companies.

Under which conditions would Tesla be undervalued right now?

I will lay out a couple of growth scenarios in which the current trading price of $257 would be below the fair value of the investment.

The first one would be an estimated EPS growth rate of 20% for the first 5 years (phase of strong growth) and a steady EPS growth rate of 8% after that (maturing phase). In this case, fair value would be $300.

If we estimate the initial growth to hold on for a longer time, and growth rates after that to be slightly lower, Tesla could still be undervalued. If we estimate the initial growth to be 25% for 8 years and growth rates after that leveling off to 6%, fair value would be $295.

If we estimate initial growth to be higher 25%, which lasts for 5 years and then levels off to 8%, fair value would be $366.

If we estimate the initial growth to be 25% for 8 years and growth rates after that leveling off to 6%, fair value would be $295.

In these scenarios, which in my mind are not the most likely, yet not impossible either, Tesla's shares were trading at a discount of 15% to 40% to their fair value right now.

In which scenarios is Tesla trading at fair value right now?

We can make a couple of assumptions which lead to a fair value around today's trading price.

If EPS growth would average 20% over the next 10 years, and EPS growth after that was 6%, the company's fair value is $266.

If initial growth is 20% for 7 years and growth rates then level off to 7%, fair value is $252.

If the initial growth lasts for 10 years at a rate of 25% and then levels off to an almost non existent 3%, fair value would still be $248.

If initial growth was 25% for 8 years and growth rate was 5% after that, fair value would be $244.

In these scenarios, the stock would be trading in a range of 5% around its fair value right now, meaning future growth would justify today's high multiples.

In which scenarios is the stock overvalued right now?

Obviously there are also scenarios, some of them not too unlikely, under which the stock would be trading above fair value right now.

If for example we assume an initial growth rate of 20% for 5 years and a growth rate of 5% after that, fair value would only be $130.

If initial growth was 25% for 5 years and growth after that would be 5%, fair value would be $157.

If we assume an initial growth rate of 20% for 10 years and a growth rate of 5% after that, fair value would be $222.

If we assume a lower initial growth rate of 15% for the next 10 years and a higher growth rate of 7% after that, fair value would be $228.

In these scenarios, growth rates would not be high enough to justify today's share price.

Which of these scenarios are most likely?

I think everyone will agree when I say that Tesla will face a lot of growth, but it is not easy to forecast exact numbers. The general assumption of a higher initial growth rate, which then levels off to a lower one after a couple of years seems realistic to me; once a company matures it becomes increasingly hard to maintain high (relative) growth rates. It is much easier to double sales from 50,000 cars to 100,000 cars than from 500,000 cars to 1,000,000 cars.

Growth in the next couple of years will be fueled by more sales of the S model, which still faces high demand in the U.S. and overseas, the model X which will be delivered from 2015 on and the model 3, which will be presented in 2016 and be sold from 2017 on.

Especially the model 3, which will be sold at a lower average selling price than the other two and thus appeal to more customers (and allow better economies of scale) will push revenues and earnings for the car manufacturer.

Another source of growth will be Tesla's Gigafactory, which will be able to produce car batteries for 500,000 cars in 2020. Since it is unlikely that Tesla will sell 500,000 cars in 2020, the Gigafactory's production would allow the company to sell batteries to other car manufacturers. For more information on this subject you can take a look at this article by Siddharth Dalal.

Revenue and earnings spikes will occur when new models are introduced, so in 2015 and especially in 2017, when the model 3 is available.

After an initial growth phase, growth rates will eventually level off, it is hard to predict when this will take place and how high growth rates are from then on. Since the world's population is growing (and will probably do so for a long time) and more and more people will have the money to buy a car (and the environmental consciousness to buy an electric one), there is room for growth for a very long time. Also, once a company reaches maturity and there is not much room to grow organically, the company can still use its cash flows for acquisitions or share buybacks (which push per share metrics).

I personally think the most probable scenarios of those I laid out here are the ones in which the company's shares trade around fair value right now.

If we take the assumption that initial growth will be 20% per year for the next 7 years and growth rates then level off to 7%, this would mean the following EPS numbers:

Year 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
EPS 3.33 4.00 4.80 5.76 6.91 8.29 9.95 11.94 12.78 13.67 14.63
Click to enlarge

If we assume that the number of shares outstanding will grow by 2% each year till 2025, we would have 155 million shares outstanding in 2025, this means the company would have to report net results of $2.3 billion in 2025.

Assuming a conservative amount of 350,000 cars sold in 2025 at an average selling price of $60,000 and a profit margin of 12%, net earnings would be $2.35 billion in 2025, not counting in any profits from batteries produced at the Gigafactory and sold to other car manufacturers.

If we assume 500,000 cars sold in 2025 (Tesla plans to be able to produce 500,000 cars each year from 2020) at an annual selling price of $60,000 and a net margin of 12%, profits in 2025 would reach $3.4 billion.

Possible risks

In all these scenarios, the author assumes huge initial growth in earnings and a positive earnings growth rate for the long term, if, by any reason, Tesla would not be able to report a growing bottom line, these scenarios (and the according fair values) would not be applicable. Possible risks I see for Tesla are:

- EVs lose their appeal and environmentally conscious customers prefer hydrogen or fuel cell powered cars by competitors.

- The amount of customers willing to change their ICEs for more environmentally friendly cars is lower than estimated and Tesla is not able to sell the amount of cars they are planning to do.

Summary

Expectations for future growth are high, and the share price reflects that. Due to new models, economies of scale and the possibility to become a supplier to other car manufacturers via Tesla's Gigafactory, revenues and earnings should grow immensely over the next couple of years. There are a couple of scenarios in which the company's fair value is around today's trading price (I think those are the ones most likely), yet I wouldn't buy at today's price, since there is no margin of safety. If the share price decreases by a substantial amount (or the company comes up with another development such as the Gigafactory) I would buy Tesla for the long haul, since it offers great growth opportunities.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.