Tesla’s Valuation: Math or Myth?
In the past few months, the stock market saw tremendous volatility as investors realized the devastating impact Covid-19 would have on the global economy. While many stocks declined significantly, a select few increased spectacularly – one in particular being Tesla. The electric vehicle (EV) manufacturer, arguably most well known for its unpredictable CEO Elon Musk, rose a stunning 769% year-over-year compared to the S&P 500’s 18.40% growth over the same period of time. Tesla’s meteoric rise can be largely attributed to two main factors: they were the first company to reach the global market with a viable EV, demonstrating the vast potential of the EV industry, and the company has consistently beaten consensus estimates in terms of earnings, deliveries, and production, creating the illusion that they can do no wrong and can grow unconstrained.
As of July 1st, 2020, Tesla is the most valuable automotive company in the world, overtaking Japanese Toyota. The company reported a profit of only $479 million in the past 12 months, compared to Toyota’s $14.6 billion. Moreover, Tesla currently has a price-to-earnings (P/E) ratio of 793.3x, compared to the P/E ratios of Toyota and Volkswagen at 12.65x and 12.82x respectively. To obtain a P/E of 12x with a $380 billion market capitalization, Tesla requires annual profits to reach $31.67 billion – or, with its net margin of 2.13%, they would need approximately $1.486 trillion in revenue annually which equates to sales of 26 million cars per year. Currently, Tesla is projected to record $28.5 billion in revenue this year with 477,750 to 514,500 vehicles delivered, a far cry from the numbers necessary to warrant its current valuation. While it is understandable to be optimistic about the company given the hype surrounding it and its quick growth to date, investors must realize that it is unrealistic for a firm to continue growing at such a fast rate – particularly at Tesla’s magnitude.
Further, Tesla faces several impediments to growth in the near future, one imminent concern being rising competition. Many major car producers have already released their own fully electric vehicles and possess far larger production capacities than Tesla. On the affordability side, a great example is Nissan with its Nissan Leaf. This electric model is $9,000 cheaper than the Tesla Model 3, the company’s most affordable car, making it a key rival. One may argue that the cheaper competitors do not necessarily outperform Tesla’s vehicles, but they do show that Tesla certainly does not have a significant moat in the EV space. Accordingly, investors’ expectations that Tesla will remain undefeated in the highly competitive market are not warranted and have led to over-valuation.
An interesting market for cheap EVs is China, with companies such as Xpeng and Nio competing for market share. They have both innovated the EV model to undercut Tesla’s price. Xpeng has released the P7 sedan, a Model 3 rival, for $6,000 less than the presently priced Model 3 at $38,550. Nio has managed to innovate further by introducing the ES8, a Model X rival, for 50% cheaper than the presently priced Model X at $126,470. As it stands, China is the world’s biggest EV market, and becoming a dominant player in the country would be a key step to justifying Tesla’s current valuation. Accordingly, Elon Musk has recognized this and plans to introduce a $25,000 Model 3 in three years to retain market share in China at a price range that drastically increases the target audience. This price drop presents a significant threat to Chinese EV companies and, if successful, could be a massive driver for Tesla.
Another worry is slowing growth in the global EV market. A McKinsey study found that the industry’s rise has slowed significantly over the past few years, an important factor to consider going forward. Further, as other manufacturers ramp up production of EVs and market growth decelerates, the fight for market share will become more intense than ever before – an environment that will outline all of Tesla’s weaknesses. One perfect example of a big area of weakness is vehicle charging times. Tesla’s Model 3 has a 75kwh battery and takes about eight hours to charge at home and public charging stations, and 80 minutes to charge at select Tesla stations. Rivals have not been able to surpass this just yet, but most companies are fighting for battery superiority and this is an area where the gap between Tesla and competitors is closing practically daily.
Finally, the largest problem Tesla faces is its production capacity. Currently, the company produces only 790,000 cars per year, creating a 25.21 million car production shortage to meet the revenue its price-to-earnings ratio implies as mentioned earlier. Tesla has planned seven other production facilities, with analysts predicting that each facility will yield an extra 500,000 cars in capacity – still less than halfway to the required target. Moreover, each facility will take a minimum of 5.6 months to plan and construct, costing an estimated $5 billion each. As a result, it is virtually impossible to reach the 26 million production mark anytime soon, meaning margin expansion and innovation are really Tesla’s two main options going forward.
The most expensive component of an electric car is the battery pack, which Tesla outsources to Panasonic. Panasonic will generate approximately $750 million in profits in the near future purely from EV battery sales, meaning if Tesla were to insource this production, they would be able to diversify their revenue streams and improve their margins up to an estimated 35%.
That being said, given the rising EV competition, slowdown in market growth, and production worries facing Tesla, the company’s current valuation is not justified and share price will fall in the near future as investors price in these growing concerns. Until we see margin expansion or top-line growth, Tesla’s valuation is simply too high to make sense from a fundamental perspective. Looking to the future, Tesla’s speed to innovate and insource technologies is the key factor that will stop them from underperforming current expectations and sending the share price tumbling.