Still Think Tesla Is Expensive? This Stat Will Change Your Mind

Tesla (TSLA 1.85%) has probably been the biggest success story on the stock market in the last few years. Even after a pullback this year, the stock is up 1,500% over the past three years, rewarding investors who held through a volatile period with 16x gains.

Tesla's status as one of the biggest battleground stocks is also no secret. CEO Elon Musk may be as well known for making controversial remarks as he is for being a visionary leader, and critics have long cheered for the company's demise. They've argued at one point or another that Tesla is bound for bankruptcy, its results are only propped up by government credits, or that competition will come along and wipe out its premium valuation.

Bears love to argue that the company is massively overvalued, saying it's driven mostly by hype, and in some ways that charge makes sense. At recent prices, Tesla has a market cap over $750 billion, while larger automakers like Ford and General Motors are valued at just $48 billion and $51 billion.

However, apples-to-apples comparisons are difficult with these stocks since Tesla is a fast-growing electric vehicle maker with high profit margins, while Ford and GM are slow-growth, low-margin incumbents. Though both Ford and GM are transitioning to produce electric vehicles, their sales of EVs are only likely to cannibalize sales of their traditional combustion vehicles. It's a classic innovator's dilemma. Tesla, on the other hand, has a clear edge with a decade-long head start in EV technology as well as advantages like its supercharger network, well-loved brand, and it doesn't face the kind of conflicts that legacy automakers will, including dealer networks that are resistant to EV's since they require less maintenance. It also offers firmware-over-the-air updates, which most of its legacy competitors have been unable to match.

Not only that, but the numbers themselves don't indicate that Tesla is overvalued, at least not compared to the broader market.

The PEG ratio

There's no perfect way to value a stock. Many investors like to use the price-to-earnings ratio, which offers a good snapshot for how a company's price compares to its current earnings.

The flaw with the P/E ratio though is that it ignores a company's future growth, which is often the most important factor in determining its value. Tesla, for example, currently has a P/E ratio around 96, but it's expected to grow revenue by 59% this year, and earnings per share is forecast to jump 79% to $12.11, giving it a more reasonable forward P/E of almost 60.

The best way to measure both price-to-earnings and growth is with the PEG ratio, a favorite metric of famed hedge fund manager Peter Lynch. The PEG ratio divides the price-to-earnings ratio by the expected earnings growth rate, generally the compound average over the next five years. Since high P/E companies tend to have high growth rates, the PEG is a good way to compare valuations of both high- and low-growth stocks.

Lynch, who ran Fidelity's Magellan Fund in the '80s, theorized that an accurately valued stock would trade at a PEG of 1, while a PEG over 1 would indicate the stock was overvalued, and a PEG under 1 would mean that it's undervalued. However, back then, stock valuations were much lower, due in part to sky-high interest rates. The P/E of the S&P 500 was below 15 for nearly all of the time Lynch ran his fund. By comparison, since 2000, the P/E of the S&P 500 has almost never been below 15, in part because of the emergence of the fast-growing tech sector. As P/E ratios have inflated, so has the PEG, and a PEG of 1 no longer seems like an accurate benchmark.

At recent prices, Tesla trades at a moderate PEG of 1.66. That ratio actually makes the stock cheaper than the average stock on the Dow Jones Industrial Average, which has a PEG of 2.41. And that doesn't include the four stocks on the index that have negative PEG values due to expected declining earnings. 

You can see the list below. 

Data source: S&P Global Market Intelligence

Not only does the average Dow stock trade at a significantly higher PEG ratio than Tesla, but 19 of the 26 companies above are also more expensive than Tesla based on the PEG ratio. In other words, when you factor in growth, Tesla is cheaper than your typical blue-chip stock.

The PEG ratio isn't perfect, of course, and divining Tesla's growth rate, especially five years from now, may be a fool's errand. But it's a mistake to discount the company's growth rate, especially since Tesla has a solid track record of beating analyst estimates in recent years, topping them in 10 of the last 11 quarters.

Tesla is the clear leader in EVs, penetrating a massive addressable market that will take shape over the next 10 or 20 years. A lot can change during that time, and competition is likely to rise, but given Tesla's early leadership and brand strength, it's the clear favorite in the industry. 

Bears will surely continue to knock the stock. But at this point, if you're arguing that it's overvalued, the numbers simply don't back that up.