In light of my recent post about Facebook’s valuation of WhatsApp, I wanted to explore another relevant case study in valuation: Tesla Motors. Tesla has gained notoriety as an electric car manufacturer in the US. Founded by the eccentric entrepreneur Elon Musk (who formerly founded PayPal), the company has developed several models of fully electric vehicle that some observers believe will transform the automotive industry. Last month, Morgan Stanley released what the WSJ called an “ambitious” research note that sent the stock surging. As the article goes on to describe:
How ambitious? Put it this way: when a research report from Morgan Stanley uses the word “utopian” 11 times — each of them in a sincere, non-ironic way — when describing the future of your company, it’s an ambitious endorsement.
The Morgan Stanley research note points towards a “utopian” society in which fully automated automobiles completely dominant the market and Tesla is at the forefront. They illustrate their potential vision in the graph below:
It is hard not to be skeptical about any valuation that relies on visions of utopia to justify its claim. As Malkiel describes in A Random Walk Down Wall Street, sell side research analysts in particular, are prone to conflicts of interest. Tesla would be a coveted investment banking client for a firm like Morgan Stanley and since the automakers stock is all the buzz right now, the bank may want to cash in a PR boost by making an aggressive prediction.
The point remains, however, that the stock is trading near all time highs. The company is worth almost $30 billion dollars, which makes it more valuable than some long standing conventional automakers such as Renault, the French auto company. I consider myself a firm foundations theory believer, so I decided to do some quick off-the-cuff calculations to see what metrics would make Tesla’s current valuation reasonable.
For starters, I looked at Tesla financial statements to determine the market capitalization and added the firm’s debt, which gave an enterprise value or a total value of the firm of about $27.5 billion. Then I assumed a (very rough) cost of capital for the firm of 15%, which is based on the fact that the firm is capitalized primarily with equity a more expensive form of capital than debt. Based on this discount rate, the steady state earnings that Tesla must generate to be worth $27.5 billion are around $4.2 billion annually. Next, I looked at traditional margins for the automotive industry – Ford and GM hover around 3-3.5% operating margins over recent years, however, I factored in that Tesla may be able to sustain higher margins because they sell a more premium product and maybe be able to produce more cheaply once they attain sufficient scale. Let’s say they can sustain a 5% operating margin in the long run then. Based on this assumption, their annual revenue must be around $83 billion. Compare this now to total annual US auto sales, which I found through IBIS World report. The annual US auto market is around $102 billion, so at Tesla’s current valuation, its steady state revenue would be approximately 80% of the current market!
As I discussed in my WhatsApp post, fundamental analysis may not be very useful if you are a trader in this company. As Keynes said, “the market can stay irrational longer than you can stay solvent.” I will not deny that the growth prospects for Tesla appear bright and there is always the potential that the company will truly prove revolutionary enough to justify its valuation over the long run. For now though, as a firm foundation believer, I would stay away from an investment in Tesla Motors.
EDIT: When I published this post on March 26, Tesla was trading at $218 per share. Since then, the stock has traded down considerably, falling below $200 for over a week and just recently crossing back above that level. The market seems to share many of the concerns that I mentioned above. There has also been pressure on the direct sales model that Tesla employs to sell its car, with a high profile legal move by the state of New Jersey, which prohibits direct auto sales. Tesla has the potential to become the next great American auto maker but still has many significant obstacles to overcome, which is why I would continue to recommend any investment in the upstart company.