One of the most renowned economists of the 20th century, John Maynard Keynes, is often credited for saying, “Markets can remain irrational longer than you can remain solvent.” Whether he actually said it or not is beside the point. It’s a wonderful quote and it is often true.
I thought about this quote because it seems to apply right now to shares of Tesla Motors (NASDAQ:TSLA). I recently said that Tesla is my favorite overvalued stock. Most rational investors agree that it is tremendously overvalued. Yet the stock just seems to defy gravity. It’s up more than 80% from its February low.
To really understand what’s going on with this stock, you have to first understand what’s going on with investors. There are really only two investment philosophies: passive investing and active investing. But there are many kinds of active strategies. Some active investors study charts and look for patterns that they believe are either bullish or bearish. Other active investors focus on momentum. They believe that stocks that have done well in the recent past will continue to do well in the near future. I believe it’s the technicians and the momentum crowd that are pushing Tesla higher now.
But there is also another group of active investors known as fundamentalists. I include myself in this group. We fundamentalists like to believe we are rational. The problem, as Keynes pointed out, is that markets are often irrational. If you are going to invest as if markets are rational, or as if they will eventually become rational, you could experience a tremendous amount of pain for an extended period of time.
Fundamentalists like to study the industry as well as the company. We pay attention to the total market for a product and to an individual company’s share of that market. We try to determine if the market is growing or shrinking. We evaluate the company’s management team. We dig into income statements, balance sheets, and statements of cash flows. We do all this in order to project the company’s future expected cash flows. Then we discount those cash flows to the present and calculate an intrinsic value for the stock, which we compare to the current market price.
Now, back to Tesla. For the most part, the fundamentals look great. This company makes a fantastic product. Tesla owners love their cars. Demand is strong and sales are booming. The entire market for electric vehicles is growing and so is Tesla’s share of that market. The CEO, Elon Musk, is a genius. Indeed, he’s one of the most visionary people of our time. The financials aren’t good, but that’s okay. Tesla is losing money today, but there is a very good chance that it will become a successful and profitable company someday – perhaps even someday soon.
So what’s not to like? The valuation, that’s what. Let’s put things into perspective. If you include expected sales for this year, Tesla will have sold about 110,000 vehicles in its entire history. The majority of those sales were in the U.S. American buyers qualify for a very generous federal tax credit, and some qualify for generous state tax credits as well. But the federal credit will be phased out once Tesla sells its 200,000th vehicle in the U.S., and it’s unlikely that the state credits will continue indefinitely, either.
Just a week ago, Tesla introduced its new Model 3 to a tremendous amount of excitement. Preorders were very strong. At last count, almost 300,000 people had plunked down $1,000 each to reserve a car they might not see for another year or two. Clearly, many of these people won’t get the federal tax credit. Does that matter? Maybe not. After all, most Tesla automobile buyers don’t need a tax credit, and they’re probably not making their purchasing decision on the expectation of receiving one.
Just for the sake of argument, let’s suppose that demand for the Model 3 and for the other Tesla models gets much stronger. In fact, let’s say that in three years Tesla is able to sell one million cars per year. That’s a big assumption. Even if the demand is there, it’s not clear that the company will be able to produce that many cars. In fact, just a couple of days ago Tesla announced deliveries of only 14,820 vehicles for Q1. That was short of the 16,000 it had projected.
Still, let’s give the company the benefit of the doubt. If, in three years, Tesla is able to produce about 1,600% more vehicles than it is currently able to produce—meaning, one million per year—that will amount to about 15% of Ford Motor Company’s (NYSE:F) current production. By that logic, maybe Tesla’s market capitalization should be equal to about 15% of Ford’s market cap. That would give the stock a market price of just $57 per share.
However, Tesla is a growing company. Ford isn’t growing much at all. And chances are Tesla will make a bigger profit than Ford on each car it sells. So Tesla shares definitely deserve to sell at a premium. But how much of a premium? Instead of 15%, is Tesla worth 30% of Ford’s market cap? Is it worth 50% of Ford’s market cap? I would argue that 50% is much too generous. Yet even at 50%, the implied stock price of Tesla is only $190 per share. That’s almost 30% below the current market price, yet even that is too rich for my taste.
Tesla is one of the most heavily shorted stocks in the market right now, and the shorts (including me) are feeling the pain this week. Which brings up a good question. What’s more rational? To assume that the market will eventually come to its senses, or to assume that it will remain irrational? I don’t know the answer to that question. But I do know this. I’m not in the market for an electric vehicle, but if I were, I would consider buying a Tesla. I am in the market for undervalued stocks. That’s why I won’t buy Tesla the stock. On the contrary, I will stick with my short position and hope that the market doesn’t remain irrational for much longer.