With news breaking that Tesla (NASDAQ:TSLA) will be included on the S&P 500 index, shares of the electric-car maker surged in after-hours trading on Monday, rising more than 14% at one point.
Many funds that model holdings based on the S&P 500 will have to pick up shares of the electric-car maker. Investors are likely speculating that demand for shares in the coming months will exceed supply as funds allocate more capital to Tesla stock.
While the growth stock's big gain following this news is notable, many individual investors are probably wondering if now's a good time to buy Tesla stock.
A major addition to the S&P 500
Though 2020 has been challenging for many companies, it's been a blockbuster success for Tesla. The company recently reported its fifth consecutive quarter of profits, and its top and bottom lines are surging. With such staggering momentum even amid a pandemic, shares of the electric-car maker have skyrocketed. Tesla now has a market capitalization of about $400 billion, up from $63 billion one year ago.
With Tesla shares surging nearly 500% over the past year, the automaker will be among the top 10 most valuable companies in the S&P 500. Since the S&P 500 index is market-cap weighted, the index and other funds that mimic the index will need to build a substantial position in the stock.
S&P Global aims for the S&P 500 index to own Tesla stock before market trading on Monday, Dec. 21.
Investors should focus on the long haul
While it certainly seems like there's a good chance that demand for Tesla shares will exceed supply in the coming months, moving the stock price higher, investors shouldn't count on it. The stock could be impacted by a number of unexpected company-specific or broader-market factors. Investors should invest in Tesla (or any stock, for that matter) based on their analysis of its value today in relation to its long-term prospects rather than on short-term stock price movement expectations. By investing based on an underlying reason beyond the potential near-term S&P 500 inclusion catalyst, investors will be better able to endure any unexpected volatility.
Nevertheless, Tesla stock's inclusion in the S&P 500 comes just as the automaker has been demonstrating consistent growth and execution. The stock's inclusion validates the company, which has built a business that can fund its expansion plans primarily with its own internally generated cash flows.
In the trailing 12 months, Tesla has impressively generated $1.8 billion of free cash flow -- and this could grow dramatically in the coming years along with the company. The automaker is still very early in its growth story. Indeed, analysts, on average, currently expect Tesla's revenue to grow 45% next year and earnings per share to nearly double over the same time frame.
For investors who believe in Tesla's business and in the long-term potential for electric cars to take share from gas cars, initiating a small position in the automaker's stock could be a good idea -- but not on the basis that shares will rise in the near term. Instead, investors should expect significant volatility and should monitor the company's ongoing performance, just as they would for any individual stock in their portfolio. Still, if the automaker can successfully capitalize on the enormous growth opportunity in front of it, an investment in the stock today could prove to be rewarding over the long haul.