# How To Value Tesla Stock

## Summary

A wide range of possible target prices are envisioned, from \$115 to \$528.

Factors that favor one estimate over the other are discussed, considering the risk factors.

Introduction

In a recent report, S&P Capital IQ slapped Tesla (NASDAQ:TSLA) with a "sell" rating and a 12-month target price of \$185 while estimating per share earnings as \$1.4 for 2016, \$3.6 for 2017 and \$5.75 for 2018. They acknowledge that Tesla should be evaluated as a growth company, but, they cite execution risk and competition for "tempering our enthusiasm." In this article, I use two different valuation methods to estimate a target price for the end of 2016. The two methods considered here are the revenue-based valuation and the earning-based valuation.

Revenue-based valuation is often used for young and fast growing companies with a hot product. A key parameter in a revenue-based method is the "appropriate" revenue multiple. By using the revenue guidance given by Tesla and historically observed revenue multiples, I will reach the target price of \$483.42.

Earnings-based valuation is mainly used for mature companies although some analysts apply it to fast growing companies also. Considering any future growth plans as "hype," conservative analysts base their estimates on the portion of business currently in operation or in early stages of deployment. In my earnings-based analysis, I will use the famous Benjamin Graham's formula by assuming the same earnings as suggested by S&P Capital, and reach a target price of \$183.11.

Since, historically the stock market valued Tesla higher than what is suggested by earnings-based estimates, it is reasonable to expect that the actual value will be somewhere between the two numbers. Averaging the two estimates, one might expect a target price of \$333.26. However, the simple arithmetic average is just one way to combine two estimates. It is also possible to assign different probability weights to each estimate and calculate a weighted average. For example, if we assume for probability of revenue-based valuation to be dominant as 75%, and probability of earnings-based valuation to be dominant as 25%, we reach a target price of \$408.34. By using different probability weights, one can calculate different target prices.

Revenue-Based Analysis

In revenue-based analysis, I will use the company guidance in estimating the revenue. Tesla says that they will sell 80-90K cars in 2016. I will use the midpoint of 85K. Historically, average selling price has been around \$110K per car. Average selling price will be higher for Model X, but since we don't know how many of each model they will sell, it may be appropriate to use the historic average of \$110K per car. Multiplying the two numbers, we reach a revenue estimate of \$9.35B.

Choosing the appropriate revenue multiple is the tricky part as it has been the most hotly debated issue in Tesla's valuation. Instead of getting into this messy topic, I will consider how Mr. Market valued this company in the past. (Mr. Market is a term used by Benjamin Graham in his book). One might expect that, in the next 2-3 years, Mr. Market will value Tesla similar to the way he did in the past 2-3 years.

At the end of 2015, Tesla stock was \$240 implying a revenue multiple of 5.98 (revenue=\$5.3B, number of shares=132.1M). One year before, the stock finished at \$223 implying a revenue multiple of 7.68 (revenue=\$3.6B, number of shares=124M). It is well known that, like price/earnings ratios, revenue multiples can grow and shrink depending on the perceived future growth potential of a company. 2014 was a year of extreme bullishness for Tesla while 2015 was filled with share issuances, Model X delays and uncertainties about the number of Model S cars sold (few people believed that they could actually sell 50K units). Taking the simple average of 5.98 and 7.68, we arrive at a multiple of 6.83.

Using \$9.35 for revenues and 6.83 as the multiple, we reach the market cap of \$63.86B. Dividing this market cap by 132.1M shares leads to a target price of \$483.42.

Earnings-based analysis

According to Benjamin Graham, intrinsic value of a company is given by the formula:

V = {EPS x (8.5 + 2g) x 4.4} / Y

In this formula:

V: Intrinsic Value of the company,

EPS: the company's last 12-month earnings per share,

8.5: the appropriate P-E ratio for a no-growth company as proposed by Graham,

g: the company's long-term (five years) earnings growth estimate,

4.4: the average yield of high-grade corporate bonds,

Y: the current yield on 20 year AAA corporate bonds.

If Tesla earns \$1.4/share this year and \$3.60 next year, this will represent earnings growth rate of 157%.

Using EPS=1.4, g=50% (instead of 157%) and Y=3.65, we arrive at V=\$183.11. Note that, if we used an earnings growth rate of 157% we would end up with \$544.27 as the target price. As I discuss below, under a certain scenario, the stock price of \$115 or lower also is possible.

My choice of g=50% (instead of 157%) follows from the company's guidance about average revenue growth for the next decade. Thus, my calculation also assumes that the rate of earnings growth will be same as the rate of revenue growth. This is reasonable (even conservative) when one considers the following factors:

Since margins will be higher once the economy of scales kicks in, the rate of earnings growth should be higher than (or at least as much as) the rate of revenue growth.

We are using \$1.4 a share as the starting number. To maintain the average growth of 50% over the next five years, Tesla would only need to grow its earnings by 25% after earning \$3.6 a share in 2017.

It may be worth pointing out that S&P Capital IQ also assumes 50% long-term earning growth rate for Tesla as stated in their report.

Combining the two approaches

While I'm bullish about Tesla, a target price of \$483.42 as suggested by the revenue-based analysis seems overblown. On the other hand, the \$183.11 target suggested by the earnings-based analysis is too conservative, since Mr. Market clearly values this stock significantly higher (for the last two years, 200-day moving average has been fairly stable at around \$240). If we combine the two estimates by using a simple arithmetic average, we reach \$333.26 as the target price for the end of 2016.

As I mentioned above, it is also possible to use a weighted average. Determination of exact weights for the two estimates is a risky business. Below, I will just point out some bullish reasons that will favor the revenue-based estimate and bearish reasons that will favor the earning-based estimate.

Bullish reasons:

The following are some of the reasons why the stock price may trend toward the revenue-based estimate:

First, taking the multiple as 6 in our revenue-based analysis (which is about same as the 2015 multiple), we reach a target price of \$434. This target price is significantly higher than the midpoint of \$333.26. Since 2016 is expected to be a better year for Tesla than 2015, a multiple smaller than the one for 2015 is difficult to justify. This reasoning suggests that at the end of 2016, the stock price around \$434 would be normal, or at least consistent with previous years, unless there are good reasons to be more bullish or bearish.

Second, if we use 5 as the multiple, we reach a target price of \$362.15. This is close to the midpoint estimate, but still higher. In the past three years a revenue multiple of 5 or less has been observed only for a brief period during an extremely bearish time. Therefore the price of \$362.15 would be the minimum value under a bearish scenario. If the company earns \$1.4 in 2016, with expectation for 2017 being \$3.6 and long-term growth potential remaining intact the end of 2016 will hardly be a bearish time for this stock. This reasoning suggests that stock price is strongly likely to be higher than \$362.15 at the end of 2016.

Finally, if we fast-forward one year and go to the end of 2017, repeating the earnings-based computations with EPS of \$3.6 as suggested by S&P Capital, we find the intrinsic value as \$434 (remarkable coincidence with the computation above). Comparing to the intrinsic value of 183.11 for the end of 2016, this computation suggests a significant increase of intrinsic value in one short year. As stock prices of growth companies tend to reach their intrinsic values one year ahead, a price of \$434 would not be surprising for Tesla.

Bearish reasons:

Execution risk and competition are the main concerns here. The promise of Tesla goes like this: "We will sell Model S and X like hot cakes, earn a lot of money, use that money to build a factory, use that factory to build the Model 3 which will sell by the millions."

Considering the narrow path to success, one can see why Tesla is one of the most shorted stocks in the world. Currently, the company owes large amounts of debt and many investors doubt (wrongly in my opinion) that Tesla can create enough equity to build a factory for the Model 3.

In Tesla's story, the only sure thing so far is the Model S. True - it is the best-selling car in its class. But competition will eventually cause margin compression even if there are no other execution mistakes on the part of Tesla itself.

Tesla heavily depends on Model X sales to recover from debt and to raise capital. However, Model X is still an unproven product. We have no idea how those cars will perform once they are on our roads. Will they explode? Will they fall apart? Will falcon wing doors keep failing? How much will the insurance premium be? Will Model X be cancelled all together? And so on. On multiple occasions, Elon Musk stated that Model X is a very difficult car to build in mass production. He said, "We will never build cars like this again."

Under the worst case scenarios, the Model X may be scrapped. This would imply that, despite the strong demand, the Model 3 could be cancelled too. Yet, the company can survive on the back of Model S sales alone. If growth of Model S sales slows down to the 30% area, with the Model X scrapped and Model 3 cancelled, even \$183 would be a lofty valuation - the share price should drop to around \$115 according to Benjamin Graham's formula. Moreover, considering the amount of debt the company has, stock price can fall far lower still. However, this scenario is highly unlikely. The Model 3 can be revived if revenue targets for 2016 are met by Model S sales alone. This can happen, for example, if Model S sales maintain the recent growth rates for the next few years. Also, the Model X need not be scrapped completely - it can be redesigned for easier manufacturing. Finally, the strength of Model 3 pre-orders suggests that Tesla can easily borrow the money it needs to build a factory to manufacture the Model 3. Still, these are some of the risks that can significantly affect the stock price.

Conclusions

In this article, a wide range of possible values for Tesla shares are suggested and justifications for each valuation are discussed. This discussion is by no means a complete coverage of all the related issues. To many readers, my discussion may not even appear to touch on the "real issues" (whatever the reader believes the real issues are). In the final analysis, we should be mindful that Mr. Market heard all the arguments for and against the company, and the stock price is what it's based on the compound affect of all the facts surrounding the company.

I'm a firm believer that it is meaningless to argue against Mr. Market. Readers must have heard arguments like:

"I love/hate the product; the stock is too cheap/expensive."

"Considering the enormous/dismal future potential, market cap is too low/high."

"Compare the market cap of this company to that of other company X."

"Company Y will produce a better product in future and it will crash this company."

"Company is losing money. They are on a path to bankruptcy."

In general, any condition that persisted for more than a few quarters is not likely to be a defining factor in the mind of Mr. Market. For this reason, arguments such as those above are generally futile as they assume that Mr. Market never heard of the argument. If Mr. Market seems to be ignoring the "warning," the argument must be either invalid or unimportant. This implies that there is little validity in arguing for a lower valuation of Tesla based on share price, competition, oil prices or execution risks. What Tesla has achieved so far in all these fronts is nothing short of a miracle.

Disclosure: I am/we are long TSLA.

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.

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