Based on Tesla's (TSLA -0.92%) sharp jump higher on Monday, following news that the company is considering another stock split, some novice investors might mistakenly conclude that stock splits increase the value of a shareholder's investment in a company. But this isn't the case.
Nevertheless, a stock split is sometimes evidence of a strong underlying business. Often, businesses that have executed well and have thus delivered significant shareholder value will pursue stock splits to make their shares more affordable following big gains in recent years. So Tesla's potential stock split is at least worthy-enough news to put the company's shares on some investors' radars as a potential buy.
Let's take a closer look to see if this growth stock is a buy ahead of a potential stock split.
The interior of a Tesla Model S. Image source: Tesla.
Tesla's potential stock split: What we know
The electric-car company intends to request shareholder approval for more shares in the form of a stock dividend, the company said in a filing with the Securities and Exchange Commission on Monday morning. Like a stock split, a stock dividend creates more shares. Each investors' total stake in the company remains the same but ownership is diluted on a per-share basis. Though Tesla said it approved management's request for a stock dividend, it still requires final board approval.
Tesla split its stock less than two years ago as part of a 5-for-1 stock split. The stock has soared since then, fueled by strong growth in the company's cash flows. These two outcomes since then provide good fundamental reasons for the board to approve the stock split.
Why Tesla stock may be a buy
All of this said, a potential upcoming stock split is not a justification to buy a stock.
To decide whether shares are a buy today, investors should look closely at the underlying business and its growth prospects in relation to the stock's valuation. On these grounds, shares are surprisingly compelling -- even after their 75% gain over the past 12 months. Tesla has simply seen astounding top- and bottom-line growth, fueled by soaring deliveries of its fully electric vehicles. And like icing on the cake, the company's vehicle software and energy businesses have become more attractive, too.
The numbers speak for themselves. Tesla's 2021 revenue was $53.8 billion, up from $32.5 billion in 2020. Free cash flow was $3.5 billion, up from $2.7 billion in the prior year, despite capital expenditures more than doubling between 2020 and 2021 to more than $8 billion.
The primary driver for all of this, of course, was an 87% year-over-year increase in deliveries, an extraordinary achievement in a supply-constrained environment. Tesla also notably continued to release regular improvements to its pricey vehicle software, bolstering its already impressive pricing power with its customers. Tesla's vehicle software now costs $12,000 for new orders.
Additionally, Tesla's energy storage deployments (measured by gigawatt hours) rose 32% year over year in 2021, and its solar deployments (measured by megawatt hours) increased 68%.
Despite all this impressive momentum, some investors might get hung up on Tesla stock's sky-high valuation. With a market cap of more than $1.1 trillion and just $3.5 billion in trailing-12-month free cash flow, the stock might look overvalued at first glance. But investors should realize that deliveries have a good chance of growing more than 50% this year, with management guiding for an average growth rate of around 50% over "a multiyear horizon."
Combine this growth with the fact that electric cars still represent only a fraction of total automotive sales globally, and Tesla's valuation starts to look more reasonable. The company is likely still in its early innings. An expensive valuation, therefore, makes perfect sense.
There are obviously risks. To name just one, if growth simply does pan out as expected, then the valuation that investors are buying the stock at today could prove to be too high.
Furthermore, there are also risks that the company's lead in electric vehicles erodes over time as competitors ramp up their investments in the space. But a small position in Tesla could be a good complement to a long-term-oriented portfolio.
