Electric-vehicle company Tesla (TSLA 4.96%) recently filed a document revealing plans for a 3-for-1 stock split.
The company last split its stock in August 2020, and shares have risen 30% since then. So if you're planning to invest in Tesla, should you buy the stock now or wait until the split takes place, which needs approval from shareholders at the company's annual shareholder meeting on August 4?
The answer may surprise you; roll up your sleeves and dive in.
What a stock split means for investors
First, it is essential to know what a stock split is and what it means for investors. A stock split is when a company increases its existing total share count by a specific ratio to lower its share price. The important thing to note is the company's total market capitalization remains unchanged strictly based on the stock split.
For example, Tesla's proposed 3-for-1 split means the automaker is tripling the number of outstanding shares on the market. After the split, investors will own three shares for every share they held before the split.
If all else remains equal, the share price will fall in proportion, so if Tesla trades at $999 per share before the split, investors will have three shares at $333 each after the split.
The crucial takeaway is that a stock split doesn't make the company any more valuable; nothing fundamentally changes about the stock. The one share trading at $999 is worth the same as three shares trading at $333.
Stock splits make shares more affordable, especially for retail investors. Companies sometimes split their stock to appeal to the retail crowd; adding more shares also boosts trading volume, meaning the stock is easier to buy and sell on a brokerage.
Asking whether to buy a stock before or after a stock split is a trick question: If a split doesn't fundamentally change a stock, it shouldn't matter whether you buy now or wait. However, you can base your buying or selling of Tesla on other factors.
The stock is near its lowest valuation
Tesla began turning a bottom-line profit in 2020, so investors can value the stock with the price-to-earnings (P/E) ratio. Its P/E ratio started high when it first turned profitable, earnings per share (EPS) are now quickly growing, and the stock's valuation is coming down. The current P/E of 89 is its lowest on record.
Data by YCharts.
Tesla still commands a considerable premium over legacy automotive companies like Ford and General Motors, which trade at a P/E of 4 and 5, respectively. However, Tesla's bottom line is swelling; analysts expect 30% annual EPS growth over the next three to five years, compared to just 3% for Ford and 10% for General Motors.
It seems that Tesla deserves the premium valuation it has, though the degree of that premium is up for debate. Nevertheless, if the company can grow like analysts believe it can, long-term investors could see the stock grow into its valuation over time.
A tough economy could hurt competitors
Tesla's profitability also comes at a crucial time; inflation is raging, supply chains are hurting manufacturers worldwide, and the economy could enter a recession. Mass-producing cars isn't easy, and Elon Musk has openly talked about how increasing Model 3 production nearly bankrupted his company.
A problematic economic backdrop could spell trouble for upstart competitors like Lucid Group and Rivian Automotive, which still burn significant amounts of cash. Meanwhile, Tesla is generating billions in free cash flow and sitting on $18 billion in cash on the balance sheet against just $3 billion in debt.
Data by YCharts.
Rivian has $16 billion in cash from IPO proceeds, while Lucid has $5 billion. This cash will buy them time, but both are trying to build more vehicles faster, which could worsen their cash burn.
A recession wouldn't help anyone, but harsh operating conditions can become a game of survival, and it's not clear that any automotive company is as financially sound right now as Tesla is.
Wrapping up
A stock split can grab headlines, but investors who buy Tesla stock should do so because of its growth and profitability. The stock could go lower over the short term, and nobody knows when a bottom might occur.
Approaching your investments with a long time horizon will give a company's fundamentals the best chance to dictate your investment returns. Good companies tend to perform well over time. You can also use a dollar-cost averaging strategy to slowly buy shares, blending your cost into an average that isn't too high or too low.
