Electric vehicle and clean energy company Tesla (TSLA 1.85%) has been one of Wall Street's biggest winners over the past couple of years. The stock traded at less than $90 per share in early 2020, and ran as high as $1,243 before sliding more than 40% in this bear market.
Such a big decline seems like an obvious "buy-the-dip" opportunity, but investors should consider the following before doing so.
Shining a light on free cash flow
Look at any earnings report and revenue and earnings-per-share (EPS) typically dominate the headlines. But don't underestimate the importance of free cash flow; it's the lifeblood of a business. It pays for the growth, dividends, and share repurchases that investors love. Meanwhile, bottom-line earnings can be deceiving because there could be non-cash items that skew the numbers.
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Many investors see Tesla as more than a car company; some consider it a technology company for its work with artificial intelligence and autonomous driving. It's also branched into other segments like solar and energy storage and insurance.
Regardless of your opinion on labeling Tesla, investors can look at the business through a simple lens -- how good is the business at generating cold, hard cash? You can see below that Tesla is essentially as good as Ford at converting revenue into free cash flow. Both companies get about $0.07 of free cash flow from every sales dollar, and it's been about equal for three years and running.
TSLA Free Cash Flow (% of Annual Revenues) data by YCharts
What premium does Tesla deserve?
Investors can take it a step further and use free cash flow to value the stock by looking at how much they're paying for that cash flow. The chart below shows the difference in valuation between Tesla and Ford, using the price-to-free cash flow ratio, which is similar to the price-to-earnings ratio but substitutes free cash flow for bottom-line profits. Despite Tesla's valuation falling dramatically, it remains about nine times as expensive (ratio of 108 to Ford's 13).
TSLA Price to Free Cash Flow data by YCharts
Consider some important things: First, Tesla is a faster-growing company than Ford. Tesla's grown revenue an average of 50% annually over the past five years, while Ford's revenue growth has been negative 2% over the same time. Additionally, Tesla is the first-mover and market share leader in the electric category, which seems to be the industry's long-term future.
I think it's an easy argument that Tesla stock should be more expensive than Ford's. Still, it's unclear just what that premium should be. Perhaps Tesla's growth eventually helps the business generate cash flow more efficiently than Ford. Maybe autonomous driving will become a big deal for Tesla, and it will add a lot of highly profitable revenue to the company. While these things might happen, the company right now is equally as efficient at creating cash profits as Ford, no matter how you label Tesla.
Tesla's enjoyed a first-mover advantage thus far in its history, but the industry shifting to electric could negate that over time. Competitors like Ford are well-capitalized and investing heavily to catch up in areas like battery technology and autonomous driving capabilities. Investors need to be careful paying up for a stock because "it's pricing in future success" because that future isn't necessarily guaranteed.
Investor takeaway
Nobody knows what the market will eventually arrive at for Tesla's long-term valuation. The stock could keep falling quite a bit further if the market determines that Tesla should be valued more like a traditional automaker like Ford. It's equally possible that shares bounce and retake new highs.
Investors should approach the stock cautiously since you can't know where the share price will go. A dollar-cost averaging strategy can be beneficial, because you would buy chunks of shares slowly over time. If the stock soars, great -- you've been adding on the way up. If Tesla falls further for a while, you'll be lowering your total average cost as you go. It's a win-win for investors.
