With Tesla (NASDAQ:TSLA) shares hitting new highs during the week (crossing $500 at one point) on news that the automaker will soon be included in the S&P 500 Index, many investors are likely taking a closer look at the stock. Some investors who have missed out on its meteoric rise over the last 12 months are likely wondering if it's too late to buy into this growth story. Furthermore, shareholders may be considering taking some profits.
While there's never a way to be certain how any stock will perform over the long haul, investors should at least do their best to understand if the current valuation seems to make sense or not. To help investors with their thinking, here's a closer look at the company's recent business momentum and the growth stock's valuation in relation to its prospects.
2020: A year of expansion
A brief review of Tesla's momentum in 2020 explains why investors have been piling into the stock. Trailing-12-month deliveries are up 24% year over year, despite the company suffering factory shutdowns earlier this year due to COVID-19-related lockdowns.
More recently, however, growth has accelerated. Third-quarter deliveries surged 54% year over year, driven primarily by a ramp up in production of the company's March-launched Model Y.
Tesla has aggressively expanded this year, including bringing its Model Y to market earlier than expected and building new production lines at new factories.
The automaker exited 2019 with the installed production capacity to produce 640,000 vehicles annually. Since then, Tesla has not only installed tooling for an additional 200,000 vehicles annually, but has also started constructing entirely new production lines at its new factories in Shanghai, Berlin, and Texas.
With such incredible momentum, and with the foundations laid for more sharp growth in the future, it's not surprising that the consensus analyst estimate calls for Tesla's revenue to jump 46% next year.
Meanwhile, 2020 was also the year Tesla swung from losing money to generating substantial profits. The automaker generated $1.4 billion of free cash flow in the third quarter of 2020 alone.
Priced for perfection?
Though Tesla's growth story is certainly impressive, the stock's valuation at $500 arguably already prices in much of the company's exciting prospects. For instance, even if Tesla were to grow its revenue at an average rate of 30% annually over the next five years and achieve a net profit margin of 7% on that revenue, it would be generating $7 billion of net income annually. This is a fairly small amount, even in relation to the automaker's near-$500 billion market capitalization today.
But there are two factors that make Tesla stock a potential buy -- even at today's pricey levels. First of all, if there is a tipping point in the future in which fully electric cars become a mainstream replacement to internal-combustion engines, Tesla is arguably at the tip of the iceberg of a massive addressable market -- and sales growth could not only exceed 30% annually, but high growth rates could also be sustained for over a decade.
Second, if Tesla eventually releases software updates that make its vehicle fleet fully autonomous -- something management believes the company will be able to do -- then the company could build one of the most valuable software businesses in the world.
CEO Elon Musk has notably said he thinks the value of its autonomous software could exceed $100,000 per vehicle. While customers aren't likely willing to drop $100,000 on vehicle software, the company could transition to a subscription model, building a massive high-margin recurring-revenue stream. This could not only accelerate Tesla's revenue growth, but also give the company profit margins in line with mature tech companies.
Buy, sell, or hold?
In short, Tesla shares could prove to be rewarding even from these levels -- although the execution and continued market-share gains required from Tesla are far from guaranteed. For this reason, I'd like a better entry point into Tesla stock -- perhaps somewhere below $450. On the other hand, the potential upside from software means selling shares could be a mistake.
So is Tesla stock a buy, sell, or hold? For those willing to endure volatility and embrace the risk of a stock priced for near perfection, the stock looks like a hold at $500. But more risk-averse investors may want to stay away and hope for a better price before they buy.