An Unconventional Approach to Valuing Tesla

Source: Tesla Motors.

Editor's note: Because of a mathematical error, a previous version of this article provided an incorrect gross-profit projection for Tesla for 2014. The Fool regrets the error.

Tesla Motors (NASDAQ: TSLA  ) at $190? One year ago no one would have believed it. The stock is up about 500% over the past 12 months. With the stock hitting all-time highs again, it's time to look at the electric car-marker's valuation. While a number of articles have made a great case for the stock's overvaluation, very few have attempted to understand why the stock could actually deserve a valuation that defies gravity.

At Tesla's price today, the devil's advocate has received enough attention. On that note, it's time to call in the ... angel's advocate.

The bear case for Tesla's stock is easy. It's rational. It usually goes like this.

  1. Whip up some standard valuation metrics -- price-to-earnings, sales per car, price-to-sales, whatever.
  2. Consider growth opportunities.
  3. Acknowledge monstrous growth as a gamble.
  4. Compare to auto peers.
  5. Shake head in disbelief, concluding the stock is wildly overvalued.

What's wrong with the typical bear case?
Despite rational cases for Tesla's overvaluation, investors shorting the stock continue to get burned. Instead of quickly concluding that Tesla is simply defying gravity because it's an irrational bubble, let's dig a bit deeper.

Here's the important facet of Tesla's valuation that the bear case often overlooks. Tesla doesn't need to report lucrative earnings to please the Street. In fact, it could be more than a decade before Tesla reports a net profit margin (earnings divided by sales) that is comparable to its peers.

No meaningful earnings, and the Street seems perfectly content; has the market lost its mind? Not at all. Actually, it makes a lot of sense.

If Tesla was reporting a lucrative net profit margin, I would be worried about the company's future competitive position. To gain a foothold among the big dogs, Tesla should be spending every dollar of gross profit possible. R&D, capex spending, SG&A -- bring it. Spend as much as possible.

Tesla is a small player. To compete with players such as Ford, GM, and Toyota, Tesla is going to need to achieve greater manufacturing scale than its current levels. Even more, with guidance for production and sales to double from 21,000 Model S in 2013 to more than 40,000 Model S in 2014, there's no reason for Tesla to aim for a meaningful net margin today.

Sure, earnings do matter. But as a small player, Tesla should focus on growing its scale and let earnings surface later on. Of course Tesla doesn't want to overspend -- but with sales growing as fast as they are today, investors shouldn't hope for a handsome net profit margin.

Hedging temporary competitive advantages
If there were competitors on Tesla's heels today, it would make sense for the company to be more conservative with spending, but there's not.

In fact, the company has two key short-term competitive advantages going for it that hedge the company's short-term success. For this reason, Tesla basically has soaring demand locked in for the next several years. This makes heavy spending a wise decision, not a risky bet.

Model S charging. Source: Tesla Motors.

The first competitive advantage Tesla sports is its dramatic lead on charging infrastructure. The Tesla-owned Superchargers are, on average, 16 times faster than most public charging stations. After an announcement earlier this year to boost construction, Tesla plans to have Superchargers within distance of 98% of the U.S. population by 2015.

But it doesn't stop in the United States. The expansion is just as aggressive internationally. A few weeks ago, Tesla launched onto the scene in Europe, when 90% of Norwegians gained access to a Supercharging station. Then, in a press release, Tesla laid out the details of its plans for its Europe expansion:

By the end of 2014, 100 percent of the population of Germany, the Netherlands, Switzerland, Belgium, Austria, Denmark and Luxembourg will live within 320 km of a Supercharger station, with about 90 percent of the population in England, Wales and Sweden living within the same distance of a charging station.

That 320 km, of course, is well within the range of the 480 km-rated range of a Model S.

Model S. Source: Tesla Motors.

Tesla's second competitive advantage lies in the car's award-winning performance. Tesla's 265-mile battery range is far ahead of its electric counterparts from various other brands. Even more, Tesla was able to achieve this while racking up a number of other accolades, including Motor Trend Car of the Year, Consumer Reports' highest rated car ever, and the highest safety rating from the NHTSA.

Groundbreaking range and impressive performance together give the Model S an undeniable value proposition. And it shows in the marketplace. For the first half of 2013, the Model S captured 10% of the large luxury-car market in the United States. The share would have probably been higher if it wasn't for supply-chain bottlenecks. Even today, Tesla remains supply-limited, selling every car it makes.

With short-term demand pretty much in the bag thanks to an aggressive Supercharger expansion and award-winning car, Tesla should be spending aggressively to ramp up infrastructure, manufacturing, and demand.

How to value Tesla
So with earnings out of the picture, how can we value Tesla? One way is to look at the company's gross profit.

By the fourth quarter of 2013, Tesla believes it can achieve a gross profit margin of 25% on sales of 21,000 vehicles, annually. With a 25% gross profit margin basically already in the bag, and an aspiration to achieve margins that rival Porsche, it's reasonable to assume Tesla can achieve a 30% gross profit margin in 2014 on its projected sales that "could exceed 40,000 units per year" (we'll estimate 42,000).

These assumptions give us a 2014 gross profit of about $2.3 billion. At today's price, therefore, Tesla is trading at about 10 times this 2014 estimate for gross profit.

Ten times gross profit is certainly expensive, but Tesla's not valued based on the Model S -- investors are counting on the company's "affordable car," which CEO Elon Musk believes Tesla can bring to market in as little as three to four years.

If the company brings the car to market in three years and maxes out its Fremont, Calif., factory's production capacity of 500,000 cars per year five years from now, Tesla's gross profit would be considerably higher by then.

Assuming the company's average selling price for its cars declines to $50,000 and Tesla reached 500,000 cars annually and maintained a 30% gross profit margin, Tesla could report a gross profit of $7.5 billion in five years.

That would put Tesla at about 2.9 times an estimate for the company's gross profit five years from now. Today, Ford trades at about 3.1 times its current gross profit levels.

If Tesla is able to accomplish this in five years, however, the business' incredible performance up to that point would probably merit a premium greater than the conservative valuation automakers have today. So let's assume, five years from now, Tesla's disruptive business model earns a premium to gross profit that is one and a half times that of Ford today.

Under these assumptions, Tesla would trade at $288, giving investors an annualized return of about 10% over the next five years.

The x-factor
This scenario leads to several conclusions.

First, there is a potential bullish scenario that could yield investors a meaningful return -- even with shares trading at $190. Even more, Tesla has done nothing to disprove this wildly positive scenario. And even though I tried to paint an extremely bullish scenario as the angel's advocate, there's always a possibility that Tesla could even outperform these expectations. For instance, Musk has mentioned that Tesla may open new manufacturing factories in Asia and Eruope, too -- a fact I didn't even take into consideration.

Second, as just a possible outcome at the higher end of the spectrum of possibilities, a bet on the stock today is speculative -- so I would avoid buying shares.

Last, shorting Tesla stock could be even more dangerous than buying shares. As long as this possible scenario is looming, the stock will likely continue to trade at valuations that make very little sense -- let's call it Tesla's X-factor. It's an American Cinderella story; the company is defying all odds. The X-factor, therefore, could lead to wildly bullish valuation metrics for decades, leaving investors shorting the stock wanting.

At $190, buying Tesla would be a gamble, selling Tesla would be rational, holding Tesla would be speculative, and shorting Tesla would be downright dangerous.

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Read/Post Comments (7) | 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 September 28, 2013, at 11:19 AM, ckgod wrote:

    People who say competitors are coming need to aware these competitors are only trying to compete with what they know about Tesla now. Even that it will take a while for them to match Tesla's range and supercharging coverage. More important is there are a lot of what's in Tesla's plan and what's going on in Tesla's lab no one outside the company knows. Looking at Elon Musk's track records I'm certain there will be a lot of new technologies coming out there in the next 3~5 years when these competitors are ready to come out with their products. Tesla is a super fast runner and has a head start the rest will never be able to catch it.

  • Report this Comment On September 28, 2013, at 11:36 AM, Pixma25 wrote:

    Nice article. Here's a couple math errors that others are likely to point out:

    "That 320 km, of course, is well within the range of the 480 km-rated range of a Model S." and then "Tesla's 265-mile battery range" but 265 miles = 424km, not 480km. Still within range of a station 320km away, but it's good to be accurate.

    Also, you say -

    "Tesla can achieve a 30% gross profit margin in 2014 on its projected sales that "could exceed 40,000 units per year" (we'll estimate 42,000).

    These assumptions give us a 2014 gross profit of $275 million. At today's price, therefore, Tesla is trading at 79 times this 2014 estimate for gross profit."

    $ 275 million. That number only works in this formula if the average price of a model S is $21,825. (21,825 x 42,000 = 916.666..million times .30 gross profit margin = $275 million)

    Since the actual average price is closer to $85,000, the 2014 gross profit estimate is $1.071 Billion, which means Tesla is trading at 20 times 2014 estimated gross profit, not 79 times. BIG difference.

  • Report this Comment On September 28, 2013, at 11:48 AM, DaivdGoldbg wrote:

    I am not sure I agree with this extremely optimistic viewpoint. There are at least concerns that have not been cautioned properly:

    1. Crazy valuation: Already almost half of valuation of GM while GM sells 100 times more cars and makes a profit per car whereas Tesla has never made a profit yet non-GAAP and no guarantee it will make a profit in the next few years.

    2. Quality Control: As it produces more and more cars, quality control can suffer, service stations can get overwhelmed and wait times could be lengthened for fixing the car. On the Tesla forum people report several minor problems and 2 major problems: 1: Due to camber, rear tires prematurely thinning on the inside and requiring a change after less than 8,000 miles, and 2: A loud hum when driving more than 60 miles per hour. Recent recall of some cars due to GPS problems. Lots of other minor glitches reported.

    3. Two reports in one week with NHTSA regarding unintended acceleration.

    4. Only a small percentage of the American or world public can afford to buy a 70,000 to 100,000 dollar car. How much profit can Tesla make on a 35,000 dollar car? The Gen-3 will not come out until 2018 by then most of the other car companies will have excellent competing EV cars in that price range.

    5. Tesla is spending tons of money on charging stations and service centers that are bound to increase as the sold cars get older and are still under warranty.

    7. High cost of labor, taxes, health care, etc in California where Tesla has an auto plant in the bay area in Fremont, CA. High cost of the continuing interest expense on debt. More funds may need to be borrowed for rapid growth, and more interest expense, since the possible minimal profit from each car will not be able to sustain rapid growth.

    8. Possibly other risks include: National or international economic downturn, rising interest rates, limited supply of lithium or rising prices of lithium. Supply problems for the hundreds of different parts that make up the car if massive scale is reached.

    9. Major investors and option holders could cash out at any time dropping the stock price by significant levels. Dilution of shares is likely for growth to continue at a rapid rate. Elon Musk could announce that he needs more money for growth anytime which can result in share dilution.

    10. Limitations in electric supply consistency in parts of the world where the electrical system shuts down often, such as India. More and more people are living in apartments and condos versus single homes. Batteries may need to be replaced after a few years since they lose a good portion of their charge power.

    At more than 190 dollars a share this stock is one of the biggest gambles of 2013. I hope the average investor does not buy at these levels because the pain can be severe if it plummets.

  • Report this Comment On September 28, 2013, at 12:20 PM, ckgod wrote:

    DaivdGoldbg There will never be gains if you don't want to take some risk. Would you buy Intel, Microsoft, Google... when they were struggling new companies but with high potentials? Of course you would but it's too late when you reached the definitive answer. There have very few companies with such a disruptive products in such a huge market like Tesla. The potential is very high and that's an understatement. Tesla and Elon Musk's track record assured us it's not going to be a fly by night company (that short's theory has been proven wrong already) and has every chance of becoming the company it says it will be and likely even more.

  • Report this Comment On September 28, 2013, at 12:41 PM, coll1951 wrote:

    The average transaction price in Europe is $135,000 (includes VAT). Current orders logged are 428, with 8% delivered. I wouldn't exactly say, this is Europe's hot new car. Delivery times in the U.S. are currently 4 weeks, from order to delivery. It appears that the demand has caught up with production. Delivery times for most domestic vehicles are 4-6 weeks. This maybe the most hyped company in U.S. history, and Tesla is keeping a close guard on production numbers. Plus 2 unintended acceleration complaints have been filed with NHSTA in less than 5 days, where there's smoke, there may be fire.

  • Report this Comment On September 28, 2013, at 12:55 PM, TMFDanielSparks wrote:

    @Pixma25

    Thanks for your comments and double-checking my math!

    On the first note, apparently The Model S rated-range is not 265 miles in Europe: It's 480 kilometers, per Tesla's website: http://www.teslamotors.com/about/press/releases/tesla-motors...

    So that's where I got that data from.

    And you are right that I did have a mistake in my math, but the attempt for 2014's gross profit wasn't as simple as the scenario you described.

    In my math I took other things into consideration like subtracting ZEV credits and adding back in deferred revenue related to deliveries of Model S (more on why I would do that here: http://www.fool.com/investing/general/2013/08/09/debunking-t....

    Unfortunately in calculating my annual run rate for 2013 I stopped short of multiplying the base quarter by four before I multiplied it by two to come up with 2014's estimate for gross profit on double the current sales at a 21,000 vehicles level.

    The new number actually shows us that Tesla is trading at 9.6 times my estimate for Tesla's 2014 gross profit. However, the 500,000 car estimate for gross profit five years from now remains unchanged, and that serves as the basis of the forward-looking valuation needed to really understand the growth priced into Tesla's stock today.

    Thanks for spotting the error. I really appreciate it.

  • Report this Comment On September 28, 2013, at 4:52 PM, muhammedatta wrote:

    Tesla, SpaceX, Solar city are all companies with a single point of failure. There is no bench beyond Elon, and he makes that very clear. All three remain majority dependent on fed subsidies. Recent swap of some of those subsidies (DOE loan payoff) for stock equity does not answer the mail regards the market for products. As we reach the end of "climate catastrophe", and people begin to clamor for redress of Gore wrongs, simultaneously his enterprises will vanish. Tomorrow, with the explosion of the Falcon 9, we will see a little bit deeper into the mind of the megalomaniac.

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