TSLA fundamentals analysis – why it’s not overvalued
ARK’s latest price target for Tesla has been the subject of a lot of discussion lately. They believe it will reach $3000 per share in the next 5 years, which based on its current market price of $654 implies about a 50% annual rate of return. If you haven’t already, you can take a look at the article they published explaining how they arrived at this price target and the assumptions they made.
I recently got downvoted for suggesting that this price target wasn’t illogical and that Cathie wasn’t crazy. So I wanted to explain my reasoning a bit more so that more people can downvote me and tell me why I’m wrong.
Now just to be clear, I’m not here to argue about whether EVs are the future, whether existing car companies are unprepared to switch to EV, or whether Tesla is an insurance play. I’m assuming that you’re already interested in investing in Tesla and the only thing stopping you is its valuation.
P/E. It’s over 1000! But is it a useful metric?
P/E seems to be the most common argument for why Tesla is overvalued. Why buy Tesla at 1023 P/E when you could buy GM at 14 P/E or even Workhorse at 23 P/E?
Let’s step back a bit. Companies can be categorized into one of three stages: growth, maturity, and decline. P/E is useful for valuing mature companies against their mature competitors, since all other things being equal we’d expect their P/Es to eventually equalize as well. For example, I recently bought Target partly because of its P/E of 22 vs Walmart’s 28 and Costco’s 34 (although one could argue that some/all of these companies are still in their growth stage).
On the other hand, P/E is less useful when looking at companies in the growth and decline phases. You could find companies with P/E below 1, but they may be value traps rather than automatic buys. If they go out of business next year, their stock will be worthless.
P/E is similarly flawed when looking at growth stocks. P/E doesn’t account for whether a company is spending a lot aggressively re-investing in itself, or if a company has small earnings now but a good chance of quickly growing into a much larger market. If you had the chance to buy a loss-making company now at $1B market cap now, knowing that its addressable market will quickly expand to $100B, you’d still make a profit over the long term, even buying at massively “inflated” P/E.
That said, P/E is still useful for measuring risk in a growth stock or upside in a declining stock. If Tesla were to transition from growth to maturity or decline, there’s no doubt its P/E and share price would decline significantly. But risk is part of growth investing; this risk exists with other growth stocks too.
While Tesla’s trailing P/E is 1023, its forward P/E is a high but less eye-popping 119. Trailing P/E is calculated by dividing the stock’s market value by its share price, while forward P/E is calculated by dividing the company’s estimated earnings in the following year by its share price. Forward P/E is a more error-prone and risky metric since nobody knows what a company will earn in the future. But it can still be useful when considering the price of a stock, since the market tends to price in expected future performance.
Comparing to some other popular growth stocks, Tesla’s forward P/E is still high but not unreasonable. PINS has 58, SHOP has 227, NFLX has 40. And at least it’s positive. Many growth stocks such as NIO, NKLA, lucid, PLTR, and LMND don’t expect to be profitable within the next year.
And while Tesla’s P/E is high it’s difficult to make a direct comparison with these mentioned companies since they’re not profitable companies in the EV space. There really isn’t another profitable EV company to compare forward P/E with, and that uniqueness/first mover advantage could be partly why Tesla trades at a high forward P/E.
That said, Tesla is still overpriced if (unfairly) comparing against mature auto-makers; GM is at 10 forward P/E, F is at 8. But if you believe those companies have a chance to become EV growth companies and won’t be weighed down by their mature/declining combustion businesses, I’d argue that’s more of a reason to buy them than to sell Tesla.
If a company is re-investing in itself aggressively, it may be incurring costs that aren’t part of its core business. Once growth slows, it may be able to cut these expenses and dramatically improve its P/E. To account for this, we can look at price to sales.
TSLA’s price-to-sales is 20. For comparison, SHOP is at 47, PLTR is at 40, FVRR is at 42, NIO is at 27, NKLA is chilling at 63619, lucid is at infinity since it doesn’t have sales yet. It’s quite an oversimplification to make these comparisons without considering what portion of a company’s expenses is related to operating costs. SHOP has better margins than TSLA for example, since it’s in a totally different business. But nevertheless, one could argue TSLA is currently undervalued by this metric, even compared to other EV companies.
A historical example
Another common argument is that the whole market is overvalued right now, and this is especially the case for growth stocks. I don’t pretend to know what the market will do in the short term, and I’m certainly not discounting the possibility of a further rotation out of growth in the near future. But I know that eventually the market will rotate back into growth stocks. You may have looked like a fool buying Amazon or Microsoft at the height of the dot com bubble, but if you held until now, you’d get the last laugh.
So let’s look at an example from a time when there was less talk about stocks being overvalued. Facebook IPO’d in 2012 at a P/E of 91.2 and price to sales of 24 (source). Both FB at the time and TSLA now have an annual growth rate of about 45%.
If we take Tesla’s forward P/E, this comparison actually makes Tesla’s price look reasonable, even though Tesla currently trades in a market with record high average P/E.
One last note – market cap. Yes, Tesla’s market cap is quite high as it’s already one of the most valuable companies in the world. At $654B, if Tesla actually reached $3000 per share it would be the most valuable company in the world (unless other top companies continue to grow as well, which is likely). The global market for EVs is expected to grow to $800B by 2027, from $162B in 2019. If this is accurate, and you believe Tesla retains its market share and current valuation, without expanding into other areas like ride hailing and insurance, then the EV market ~5Xing could justify Tesla’s share price ~4.5Xing.
While Tesla is certainly overvalued by trailing P/E, this is a somewhat flawed metric, and by looking at other metrics like forward P/E, price-to-sales, and growth rate, an argument can be made that Tesla is more-or-less fairly valued, and potentially even undervalued. This argument holds even if looking at historical examples from less frothy markets, such as FB after its IPO in 2012.
Like any growth stock, Tesla is a high-risk investment, since its future share price depends on future growth of both the company and the EV space. But the potential for reward is also higher.
I’m not a financial advisor and this isn’t financial advice. Positions: $4k in Tesla shares, $15K in ARK LEAPs
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March 21, 2021 at 01:09PM