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Is Tesla Motors Valuation Getting out of Hand?

When it comes to valuation, Tesla Motors' (NASDAQ: TSLA  ) stock price premium is second to none among auto manufacturers. The company trades at 142 times forward earnings estimates and about 15 times its trailing-12-month revenue. As if the six-month run-up of 188% since Jan. 1 wasn't enough, the stock has appreciated another 21% on top of that in the last month and a half. When is enough enough?

Tesla runs a lucrative operation
First, the positive. As Tesla Motors ramps up production, the company's manufacturing process benefits from greater economies of scale. This, of course, is no surprise -- it's a basic rule of thumb in business. But to what degree will Tesla benefit?

Already, the company has "reduced the hours required to build a car by almost 40% from December to March," asserts Tesla's first-quarter letter to shareholders.

Tesla Model S undergoing assembly. Source: Green Car Reports.

This, along with a number of other benefits associated with scale and $68 million in sales (12% of revenue) of its zero-emission vehicle credits, or ZEVs, helped the company double its gross margin from last quarter, to 17%.

In the first quarter, Tesla's gross margin of 17.15% outperformed a number of auto manufacturers. Ford (NYSE: F  ) , for instance, reported a gross profit margin of 16.21% during the same period -- and that was on sales of about 1.5 million vehicles. To make this comparison fair, however, it's important to note that Tesla's core auto business' gross margin was just 2% in the quarter, according to Morgan Stanley's Adam Jonas. ZEV credits were a major contributor to the company's 17% gross margin, says Jonas.

But here is where things get really interesting. In the first-quarter letter to shareholders the company reaffirmed its guidance for a gross margin of 25% by the fourth quarter of 2013, "assuming zero ZEV credit revenue".

Can Tesla's improving gross profit margin save the company from the Street's lofty expectations? Probably not by itself, but it's definitely a start.

A gross margin of 25% is about 1.46 times the company's current gross margin of 17.15%. Taking Tesla's first-quarter gross profit of 96 million and multiplying it by 1.46, Tesla could earn a gross profit of 140 million every quarter at today's revenue levels and with a gross profit margin of 25% -- that's 560 million annually. In other words, Tesla trades at 25 times a very conservative estimate of 2014 gross profit. Conservative or not, 25 times 2014 gross profit is a significant premium. Ford trades at just three times its trailing-12-month gross profit. 

It's about expectations
Tesla will need far more than gross margin improvements to grow into its valuation. Fortunately, gross margin improvements are not the end of the story for Tesla. Last quarter alone the company's sales increased by 83% from the prior quarter. Can sales growth and gross margin improvement combined save the stock from its valuation?

The average analyst estimate for Tesla's 2014 revenue is 2.32 billion. Assuming a gross margin of 25%, Tesla's gross profit would equal 580 million in 2014. At today's price, that means Tesla is trading at about 23 times its 2014 gross profit, assuming a 25% gross profit margin and 2.32 billion in revenue (146% higher than Tesla's trailing-12-month revenue of 945 million). This is definitely a lofty expectation.

As Tesla's stock continues to rise, I'm withdrawing my buy recommendation. Importantly, however, I don't believe this means current investors should sell. I'm a big believer in holding onto companies as long as they are meeting or exceeding my original thesis -- and Tesla hasn't failed me on that front. In other words, I don't sell good businesses (no matter the valuation), but I do consider valuation when I make an initial buy decision.

As price increases relative to the underlying fundamentals, risk increases too. Tesla is too expensive to buy, but as a business firing on all cylinders I wouldn't sell it and pay taxes on my gain yet either.

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Read/Post Comments (4) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 18, 2013, at 7:42 AM, AlaaSadek wrote:

    Don't you think that if Tesla gets a big fat contract from the army then all these numbers of yours should change and the price of the Tesla stock will be much higher?

  • Report this Comment On July 18, 2013, at 10:17 AM, naterstg wrote:

    I still think the biggest mistake being made when analyzing Tesla's stock is the comparison is being done solely to other auto manufacturers. I think some light is shed on the valuation when you look at it like a tech company. Also, when was the last time an American auto manufacturer startup was valued on the stock market... especially one bringing new technology to the market? No wonder the street is having such a hard time with this one.

  • Report this Comment On July 18, 2013, at 9:51 PM, SteveTG3 wrote:

    looking at Tesla's prospects based on 2013 and 2014 earnings without modeling 2020 earnings is like looking at a child his/her first two years and dismissing his/her prospects of reaching 3 feet in height.

  • Report this Comment On July 19, 2013, at 1:04 AM, sliderw wrote:

    Valuing Tesla comes down to two questions: How's the moat? How's the demand?

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