Tesla’s Valuation: an Ode to Musk
This same time last year, Tesla’s share price was at USD 215, and some analyst predicted that Tesla’s share would eventually collapse to USD 10. Fast forward 1 year later, while other automakers are struggling to deal with the fallout of the pandemic that will potentially delay their plans to transition into EVs by several years, things seem to never look brighter for Tesla . Its share price, along with other tech companies, has continued to “defy gravity” and lurch upwards, hitting another incredulous record high (USD 2150).
It goes without saying that the stock market in the short term is driven by mood, momentum, FOMO (Fear Of Missing Out), substitute effects, etc. This is especially accentuated in the case of Tesla. The bear gang has been lamenting on the over-valuation of the stock, pointing to the fact that Tesla, a battery and software company masquerading as an automotive manufacturer that produces only a little over 365k units per year (2019), has a market cap bigger than the combined market value of the three biggest German automakers (Daimler, BMW, Volkswagen) whose combined sales volume dwarfed that of Tesla.
I am writing this post to assess the bears’ claim, to arrive at an intrinsic value for Tesla’ shares, and to elaborate some nuances to this valuation.
Getting started — assumptions
- Sales Forecast
The most intricate part of Tesla’s valuation is its revenue forecast. The bear gang has attributed the stock’s over-valuation to the bull gang’s seemingly unhinged optimism on Tesla’s ability to grow exponentially in the coming years.
What they probably did not factor in was Tesla’s potential to leverage its technology and venture into other more profitable, higher-margin businesses such as software licensing (Full Self Driving is valued at USD 100,000), energy (which Elon Musk predicted to be on par with the automotive business), and even insurance. Thus, it is imperative to forecast the revenues for each of Tesla’s current and future businesses.
To see details of my line of reasoning for revenue development of each business of Tesla (including the current ones and the future ones), please have a look at my attached Excel spreadsheet (sheet “Sales Analysis”). For this post, I will try to keep the post as clean as possible and present Tesla’s revenue projection in the following graph:
- Investment efficiency
Sales to Capital ratio represents investment efficiency — how much sales the firm generates after investing 1 dollar of capital. Tesla, a young company that has a lot of room for growth still, earns 1.9 dollars of revenue for each dollar of capital it invests, outperforming the industry (industry average of 1.06).
In this model , I assume sales/capital (necessary for reinvestment calculation) to remain high at 1.9 for the first five years, after which the ratio will, due to diminishing return effects, gradually drop to the aforementioned average industry
- Operational efficiency
Tesla’s EBIT margin of 5.59% (adjusted for R&D and leasing) is slightly better than the industry average (4.79%) and will continue to rise in the coming years as they expand to higher-margin businesses (insurance, software licensing). I model the company’s EBIT margin by 2029 to stabilize at 12%, in line with Tesla’s guidance for their steady-state EBIT margin (in the lower teens)
- Cost of capital
The table above summarized Tesla’ cost of capital at the time of valuation. Low cost of debt is due to depressed risk-free rate rates (0.71%) as a result of the Fed’s constant printing of money. As the company matures, I assume Tesla’ cost of capital will decrease to the level of a typical mature company (risk-free rate + 4.5%).
Result and analysis
The sum of all present value of FCFFs and Terminal value amounts to USD 139bn. However, as I attached 5% of failure probability for Tesla, it knocked down USD 8.5 bn off the valuation. Total equity value as a result of subtracting debt and minority from and adding back cash to the operating assets’ value is USD 128bn. 30 million options outstanding with an average strike price of USD 279 reduces Tesla common equity’s value to USD 87bn, corresponding to a value per share of USD 467 (186mn shares outstanding).
Despite generous assumptions about growth (revenue increase by 6.5x over 10 years), significantly above industry average operational and investment efficiency, it is quite a tall order to justify its current share price of over USD 2000 these days.
Knowing that my model is sensitive to key assumptions about growth, necessary reinvestment, and operational efficiency, I conduct sensitivity analysis to determine to which factors the model is most sensitive.
If I were to value a traditional automotive manufacturer such as Daimler and Volkswagen, I would use near the European risk-free rate (currently negative) as the terminal growth rate to reflect the fact the company is at the end of its life cycle.
My DCF model assumes a 3.39% for Tesla’ terminal growth rate, however, to reflect the company’s potential for growth as it enters new businesses (renewable energy, software licensing, and insurance). As the terminal growth rate varies, the stock’s value changes significantly, suggesting this terminal growth rate to be one of the most sensitive factors in the model. At 7% steady-state growth rate, the stock can be worth as much as USD 8201. That should explain Ark Invest’s target price for Tesla (USD 8000). However, to assume a company to grow more than 5.5% per year at steady state is not sensible, given that consumption growth has decelerated and that there is yet a paradigm-shifting technological breakthrough in sight to justify such assumption.
Two other important assumptions that I made in this valuation are investment efficiency and operational efficiency. As Tesla increases its investment efficiency from 1.0 to 2.4, its value grows incrementally, implying that sales/capital ratio is not a sensitive factor in my model. However, if it boosted its operational efficiency (EBIT margin) by, for example, entering businesses with larger margins (software licensing, renewable energy, insurance), Tesla could dramatically pump up its value per share.
I also simulated Tesla’ value per share with three varying key factors (growth, reinvestment efficiency, and EBIT margins) and got the following result:
The mean value for Tesla’ stock is USD 631 while the median is USD 509. The 90% Confidence Interval for Tesla’ value per share is from USD 73 to USD 1593. From the result of this simulation, I would not invest in Tesla until the price tag drops lower.
If you are asking whether I am confident enough to short the stock or buy a put option (one of my friends did ask!), my answer is no. While I am confident in my valuation of Tesla, with the narratives that I have laid out for the future of the company (moderately high growth, entering high-margin businesses), I am reluctant to short the stock, for shorting is an expensive endeavour, and I do not know when a catalyst event will happen to correct Tesla’ share price. The legendary investor Bill Ackman has twice committed this blunder, first with MBIA and second with Herbal Life. He was eventually proven right but suffered quite a bit along the way, for he did not control the timing of the catalyst events. I am determined not to make that mistake.
Furthermore, Elon Musk, with his quirky yet likeable persona, can keep up this fight for years. Despite hurdles from multiple fronts, he has managed to survive the toughest of all assaults, from getting ousted as CEO from the very company he founded in the 2000s, to Tesla’ near bankruptcy in 2009 and SpaceX’s rocket explosion in 2016. With such a track record, he is the man you do not bet against. If you burned Elon Musk until there is nothing left except his core, you would find neither a business magnet nor an engineer, but a preacher, for he has an almost-divine ability to profess his belief, to rally the smartest people behind him, and do impossible things (making powerful and sexy EVs, shooting rockets and one of these EVs in space). Thus, with a preacher at the helm of the company, Tesla’s share price might stay elevated for a long time, now that other competitors are short of breath.
At this current price of USD 2153, with my narrative of how Tesla will fare in the future, I will remain an ardent supporter of Musk’s Tesla, albeit only emotionally. Only when I see a fundamental change in Tesla’s business (the coming Battery Day might reveal some) will I reexamine my valuation.