Tesla has so captured investor's imagination, that earnings and conventional business metrics may not even matter anymore. This article attempts to clarify 3 things: is Tesla's growth story currently overpriced relative to value? Is a 700 billion valuation possible? What are the investment strategies at play here? After all, the bulls claim that if a visionary can send rockets to space and back with plans to colonise Mars, surely he can get a few million cars on the road right?
But.. the answer to this investment is a huge no.
Whilst Tesla is a fantastic pioneer in the electric vehicle industry with revolutionary idea's and cutting edge-technologies, the current share price takes into account not just perfect execution, but also optimistic results. This is further reinforced by the fact that the so-called cutting edge technologies are projected to complete by 2020, and commercialised after "2-3" years following regulatory approval. Given the current condition of the market, and the pateince required for this stock, I advice prospective investors to sit this investment out.
Intrinsic Valuation: Discounted Cash Flow
Elon Musk has stated two goals to be reached by 2020; 500,000 in vehicle unit deliveries, with 50% annual revenue growth; using this statement as the basis for our revenue projection, an optimistic DCF yields a share price of $130.
Coming from a place that adores Tesla's and being a Musk fanboy personally, I don't see this growth rate being realized at all given how saturated the automobile market is. Even if we do account for such positive assumptions, Tesla seems to still be grossly overvalued. But that's not all- please consult the explanation below the DCF.
Weighted Average Cost of Capital: 8.84% (refer to table below)
- Risk free rate and Beta: assuming a risk free rate of 1.50%taken from the 10-year US treasury yield, and a levered beta of 1.25. Given Tesla's relatively young age, and it's guidance to branch into consumer electronics as well as solar energy, I found it very hard to estimate an organic beta value. Given this complication, the beta value will be taken from Reuter's. Therefore, I assume a risk free rate of 1.50% taken from the 10-year US treasury yield, and a levered beta of 1.25.
- Equity risk premium:
- Cost of Debt: Given that Tesla is 3.4 billion dollars in straight debt with 570,864 in debt from operating leases, and with interest payments of 118.9 million dollars as of 2015, the cost of debt is 2.093% after the 30% tax deduction.
Revenue model: As per Musk's guidance to 50% annual growth for "several years", my DCF model assumes 50% revenue growth until 2021, before declining by 10% in each incremental year to terminate at 5% in year 10. Given Tesla's track record of growing annual revenues by 50% from 2013 onwards, with the exception of last year where revenue grew by only 40% (due to operational fallbacks that are inherent in young automobile companies), I deem this assumption slightly bullish. Whilst a terminal growth rate of 3% is unusually high (US GDP growth averages out to be 1.1-1.8% presently), I believe this is achievable considering how rampant growth has been in the clean energy sector, Tesla's mass market appeal, and the hefty reinvestment plans made today. For context, we are looking at a company that will make BMW's current revenue by the 10th year of the DCF.
Reinvestment: This DCF model employs a sales/capital ratio of 2.5 to forecast reinvestment needs. According to this ratio, 1 dollar of reinvestment will generate an extra 2.5 dollars in revenue. The sales/capital ratio of technology companies is typically 2.24, so an optimisitc figure should hover around 2.5.
Taxation and NOL: Since Tesla has been forecasted to be making losses in the early-to-mid stage of the model, the firm is exempted from taxation until net operating loss clears off, which occurs in year 8 (2024).
Operating margin: In 2015, Tesla recorded an operating margin of-17.7% - much to the dismay of investors. However, assuming that Tesla will be able to harvest above-average operating margins (similar to that of a mature luxury automaker alike Porsche, BMW, Mercedes) through greater supply chain cost optimisations by the later stages of its businesses, and following Musk's guidance that operating profitability (excluding Capex) will be reached at around 2020, we increase operating margin by 2.97% incrementally to reach 12%, which is by year 10.
In summary, my DCF model chronicles an optimistic narrative that Tesla is largely a technology company looking to deliver superior electronics, through battery and software in its automobile and solar roof business. My DCF assumes that Tesla's top-down marketing strategy will eventually invoke mass market appeal for it's products and services, at an above-average margin. The reason why I assumed an above-average pricing ability is because of Tesla's brand assurance, and the network of proprietary technology that has been obtained through its first mover advantage. Given relatively optimistic assumptions with regards to its total addressable market, profitability, and reinvestment needs, Tesla appears to be overpriced by 50% relative to a valuation of $130. If my DCF is correct, people are paying a 50% premium beyond Tesla's core business simply because of goodwill and the CEO's promise.
Returning to my introduction, where i proposed the need for clarification on 3 things:
1) Is Tesla currently overpriced relative to intrinsic value?
According to my DCF model which, may i remind you, takes into account bullish assumptions, it appears that Tesla is pretty well overpriced at the moment due to: fanboys of Tesla, Electric vehicles, and Musk's vision, as well as speculators that hope to cash in on this enthusiasm for the brand.
2) Is a 700 billion valuation possible?
Assuming moderately positive figures in my DCF allows me to arrive at a market capitalisation of 22Bn. How Musk plans to reach 700Bn in valuation beats me, but without industry-wide disruptions that changes the definition of what a standard automobile is, and strong bullish speculation on Tesla's part, I find it hard to be convinced of anything close to such a gigantic valuation. Whilst we have seen much evidence regarding Tesla's prospect of being the disrupter i.e. with it's advanced battery technology and technical perks like autonomous driving, the chances of this happening against a plethora of established industry giants with a very concentrated interest is immensely slim. Even if a disruptive cycle is set in motion, it would take a very long time. But who knows; what Apple did with the smartphone market and Netflix to home video could very well occur with Tesla to the automotive/battery industry - but this would be an infinitely difficult quantity to forecast. And if your basis for investing in this vision is because you believe Musk meant what he said, then that is a very risky investment strategy that requires you to hold for atleast several decades.
Having said that, I do faithfully believe in Tesla's mission in the long-long run and it's capacity to inspire many more (mass market)people than what it currently reaches out to. If this becomes true, Tesla's market capitalisation will definitely merit a much higher value than present levels.
3) What are the investment strategies at play here?
Keep the faith
If you have Tesla or are planning to buy it, then it would be advisable that you "keep the faith" and hold for a long period of time; at least until 2030. The company has a great brand with Iron man as its management, but terrible cash flows - making it a horrible investment pitch for value investors. Yet despite it's start-up status, Tesla has actually become the industry pioneer for electric/battery/autonomous technologies. Clearly, Tesla is the industry visionary with a loyal following (400,000 orders for an unreleased Model 3) and surely it's vision will become realised with time and patience.
Surf the volatility.
Rather than considering Tesla's value proposition, many people and particularly day traders view it as a "pricing game". Time and time again, the stock has dropped to the mid 150's only to rebound to the 220's. This is less to do with the company's cash flow, and more to do with Elon Musk's narration, with respect to how it affects momentum as well as investor moods. If you can grasp investor mood shifts and take advantage of that - then kudos.
Even if the share price does not dip, potential upside is tiny (in it's current price) until the release and the actual execution of the next few master plan's, assuming Tesla's vision is as big as people expect it to be. To any investor, waiting and grinding for Tesla to take the reins through the renewable energy revolution is an outrageous expectation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.