Tesla, the world’s electric vehicle manufacturer, created a business environment favorable to market changes through successful implementation of disruptive innovation strategy. Ever since the company revolutionized the automotive industry adding a tech dimension to it, the share price of Tesla, has increased by roughly 30 times in value from its IPO in 2010 with a start price of $17 per share to over $500 (see Table 1) as of April 6, 2020 (Market Watch, 2020). The price estimate increase was mainly driven by the company’s expanding production capabilities, improved cost management and strong products pipeline, which should enable it to post relatively sustained profitability in 2020 (Govindan, 2020). Leveling up to companies such as Tesla has become the object of desire for thousands of enterprises. However, it is believed that Tesla is strongly overvalued: it remains loss-making with the adjusted net income standing at -$0.4bn and -$0.2bn and EPS (Earning Per Share) at -$2.87 and -$1.33 in 2016 and 2018 respectively (Team, 2020). The mounting competition in the EV market from mainstream automakers, decreased sales from China and the global spread of coronavirus in 2020 can also cause the stock fall off the cliff. Some started to raise questions: Does the share price for Tesla reflect what it is really worth? If disruptive models are, in fact, something recent, how is it possible to evaluate whether a company can be both disruptive and profitable, and what would be the adequate discounted cash flow equity based on the company’s life cycle as different risks mean distinct discount rates?
Table 1: Tesla, Inc. (TSLA), Nasdaq GS – Nasdaq. Currency in USD (Source: Yahoo Finance)
This article discusses alternative answers to important questions such as the ones mentioned above, as well as shares real life cases that demonstrate misinterpretation of performance, value and price.
Price, Value and Performance
Within the day to day choices, we all make the connection between these three concepts, even without realizing it. Just picture yourself deciding which car to buy. The doubt is between buying or not a new Toyota Corolla. Preferring or not median sedans, fitting the buyer’s style or not, this car model wasn’t chosen at random: this is the most sold car around the world (over 40 million) historically. It is simple, efficient and affordable. This way, the quality of the product itself is not considered (in case of investments, it would be the company’s asset performance). Let’s say that you walk into a car dealership, and this brand new vehicle is offered for $5,000 USD. Would you buy it? The same example can be put in an alternative manner. If this Toyota Corolla was offered for $35,000 USD, would you still buy it?
There are a few key questions that must be answered in order to demystify the price-value relationship. The first question would be: does the Corolla stop being a good product if its selling price goes up? The answer is no. It’s intrinsic value, the customer’s motivation as to why he or she would buy this product, does not change depending on its price. What changes a lot is the product’s attractiveness. Attractiveness means the desire that a buyer would have, if motivated, to acquire a product.
The second question is: where does value come from? A company asset’s value depends on several factors, and it is not easy to answer this question. Of course, performance affects value, not the price! Going back to a company’s (not a product’s) valuation, it’s important to know the main factors when making business management decisions, as these decisions must be valuable. In other words, they must increase the company’s value.
The thing is that human life is finite, which means that determining how we spend our financial gains is basically defined by Maslow. First, we eat and live. Second, we dress ourselves better. Then, we acquire better assets, and if by competence or luck we are successful, there is a possibility of allowing ourselves to enjoy a few luxuries. This defines the hierarchical order of where money is spent by almost all rational and conscience human beings.
Well, why would someone save financial resources? Let’s put it another way: Why would an individual invest his or her resources instead of relishing it, which is basically the only purpose of having money at all? The only logical answer to that is insurance (uncertainty regarding the future) and surplus value of resources (relishing more in the future, better with no working). The first question to be asked when valuating an asset is how much income will be generated from it, in the future. Both Graham (1949) and Buffett (2008) argued that the easiest part of business, is determining its value. All you have to do is to discount future cash flows (DCF) of the business to a determined rate that represents its risks.
Despite Damodaran (2006) suggesting several alternative ways to evaluate an asset, such as market multiples, liquidation value or cost of asset production, he still recommends discounted cash flow – DCF – as the most accepted model. If an asset is so poorly managed to a point where its value is equal to how much it costs, it is better to not acquire it. As Buffett’s famous saying goes: “It is better to acquire a great company at a reasonable price, than a reasonable company at a great price” (2008). Here is how DCF is calculated. As stock value is a forward-looking measure and driven by the company’s future earnings, DCF is based on a company’s future cash flows. The discounted cash flow model estimates a firm’s enterprise value by discounting its future free cash flow to firm (Damodaran, 2006). Since FCFF is the cash generated by the company after all operating and capital expenses, but before debt service and shareholder remunerations, it is discounted by weighted average cost of capital of the firm. The generic formula below shows us how it works:
A more detailed description of each element of the equation is found below:
- The first step is to estimate the future cash flow (FCF) of the company for the next couple of years (usually 10 years) and the growth rate after this time (g);
- In the second step, the cash flow estimates are discounted using an annual discount rate (r), which reflects the uncertainty of this future cash flow.
- The next step involves the estimation of the terminal value of the company, a so-called lower growth rate (as it is assumed that the company will grow at a steady rate for infinity).
If it’s that simple, then why is the market so volatile? To figure it out, let’s take a look at some examples.
Tesla Inc, established in 2003, is the world’s first company solely specialized in development, design, production and sale of all-electric vehicles. The firm also manufactures, installs and maintains solar and energy solar storage systems. In automotive segment, Tesla has stepped in the growth phase of its business life cycle with the introduction of its new EV models, thus ramping up its revenue generation. However, the company is still at its early stage with relatively high cost of production and cash burning nature, which is typical for capital intensive companies (Davronov, 2019).
Table 2: Tesla's revenue from FY 2008 to FY 2019 in million U.S. dollars (Source: Statista)
In addition to EV, Tesla has also established global network of 1.5 million supercharger stations, vehicle service centers and other facilities to support its existing and potential customers in North America, Europe and Asia, and the management is dedicated to significantly increase the number of such stations in coming years to accelerate the adoption of its vehicles (Govindan, 2020). But despite the rapidly growing sales volume and revenue of the company, Tesla’s production costs are still relatively high, and its net income has not turned into positive yet since the establishment it has paid no dividend historically (Reinicke, 2020).
Table 3: Tesla's net income/loss from FY 2013 to FY 2019, in million U.S. dollars (Source: Statista, 2020)
At the same time, it is noticeable that Tesla’s stock price has shown a significant increase despite the firm’s poor financials. The main drivers of such share price have been the market’s overreaction to the news and trends that appeared in the market, rather than fundamental analysis (Sheetz, 2020). It is argued that share price spike events were mainly followed by the announcement of the new EV models and future projects in energy generation and storage segment that was supported by speculative announcements of the CEO Elon Musk. If the stock price performance of Tesla is compared with the one of its rivals and the industry index, it becomes clear that the company largely outperforms its competitors despite the fact that it has been generating negative cash flows and producing lower number of cars (see Table 4).
Table 4: Tesla vs Ford vs GM vs FCA Market Cap (Source: Tesla Is The Most, 2020)
Here comes a question: to what extent is Tesla overestimated? DCF can uncover that. To begin with, we have to get estimates of the next ten years of cash flows. It is possible to use analysts’ estimates, but if they are unavailable, the previous free cash flows (FCF) from the last estimate or reported value are used. In the given case, the following figures and analysts’ projections (Guru Focus, 2020) are used:
Earnings Per Share: -$5.07
Growth Rate in the Next 10 years: 5%
Terminal Growth Rate: 4%
Years of Terminal Growth: 10
Discount Rate: 12%
With the stock price standing at $543.2 (as of 07/04/2020), the Growth Value is -36.16 and the Terminal Value is -18.09. The Fair Value (Intrinsic Value) of the company is the sum of future earnings at growth stage and a Terminal value, which would be $-54.26 (Guru Focus, 2020). If the Fair Value is so low, why is Tesla real market price so expensive?
In order to understand it, it is necessary to go back to the theory and answer the following question: where does value come from? In case of Tesla, there are several factors that form the perception of value:
- Future potential: if the market believes that electric vehicles are set to become the new norm and solar roofs really take off, Tesla is definitely going to be really profitable business. The company’s value is mainly fueled by its long-term growth perspectives and market’s expectations of the future success (Sheetz, 2020).
- Tesla is a tech-like company, as perceived by the market, rather that than traditional automobile manufacturing firm due to discrepancy in their business profiles. For this reason, it seems more reasonable to compare Tesla with high profile tech names, such as Apple or Netflix, instead of traditional car makers (Davronov, 2019).
- Innovation: Tesla managers realize the need for innovation in order to stay on top of expertise and compete for the place in the sun in the industry. Non-stop engineering and innovation initiatives are the lifeblood of the company, which is makes it even more attractive in the stock market (Field, 2019).
Thus, this discrepancy in the fair value and actual market price can be explained by the market’s overoptimistic expectations on Tesla’s future growth. Still, there are ample questions to doubt: electric vehicle adoption remains extremely low; there has been a significant decrease of car sales in China and the company still has not proven it can manufacture cars for the mass use worldwide (Sheetz, 2020). Some analysts even believe that Tesla looks like a speculative bubble, which sometimes occurs in financial markets, especially near the end of bull markets (Fitzgerald & Li, 2020). More than that, despite all the uncertainties and the market volatility, Tesla has some internal issues to be solved. As a rule, ambitious goals and outsized claims generally tend to come at someone’s expense, and in this case, it is numerous factory workers who pay the price for Musk’s great plans. Toxic corporate culture, long hours, stress, unrealistic goals and a lack of job security are among the main complaints Tesla’s current and ex-employees report. Indeed, due in part to the high expectations of the CEO, the company is known as a demanding place to work, and while some employees find Musk a frustrating and temperamental boss, others find their jobs inspiring and exciting (Matousek, 2020). At the end of the day, some concepts appear to be relative, be it the corporate culture perception or company’s stock value.
The model of Discounted Cash Flow is simple, but premises that determine the value are not. Ability and knowledge are required in order determine intangible assets that establish cash flow yield, as well as risks involved that clearly affect discount fees. With that said, the definition of price can be explained by how much an asset is paid for, while value is the result of a company’s future earnings, adjusted to the risk of the future not happening in a predicted manner. DCF analysis of Tesla yielded shares prices lower that the actual market price, although a broader range of factors, such as market volatility and a possible economic downturn caused by the COVID-19 outbreak in 2020 should be taken into account for more accurate estimates. Market innovation or news, that tend to greatly influence stocks, can then be defined as access to venture capitals. The opposite is also considered to be true. Therefore, what changes in the business valuation of each life cycle of the company, is the appetite for risk that each specific investor has. And, undoubtedly, boldness and innovation can make the stock market rally faster, higher and stronger.
Sources and references
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