While some may resist it, electric vehicles (EVs) are becoming the way of the future. Factor in the U.S. government passing the Inflation Reduction Act, which extends a tax credit to purchases of new and used EVs, and the trend becomes even more apparent.
With such a massive consumer shift in the works, investors need to be thinking about whether this is an area of investment opportunity. I believe it could be, and investors should look at one company in particular to capture this trend in their portfolio.
The EV leader
Surprise! My top pick in this space is Tesla (TSLA 1.85%). While this really isn't much of a surprise, I genuinely believe it is the best company to own in this space.
My biggest reason is its first mover advantage. Tesla has been the name in EVs for a long time. While many automakers have dabbled in the space, none have created a product that has captured an audience like Tesla.
However, many pundits would argue that Tesla's days of dominance are numbered now that legacy automakers like Ford (F 0.47%) and General Motors (GM 4.37%) are stepping up their game.
I disagree. First, the legacy automakers must spend billions of dollars reequipping their factories to build EVs.
Second, Tesla has a superior margin profile. Because Tesla doesn't have a vast dealer network, it doesn't have to share profits with the middleman. It's unlikely legacy automakers will be able to switch away from this practice, as franchise laws are already in place to protect the thousands of dealerships across the U.S. Ford's CEO Jim Farley has expressed his desire to switch to this model, as he believes Tesla makes about $2,000 more per vehicle by going direct-to-consumer.
This difference stacks up over a long time and gives Tesla greater resources to invest in new technologies or reward shareholders as the company matures.
Finally, Tesla just received a boost from the U.S. government to keep its product competitive. Formerly, once a company sold 200,000 EVs, the $7,500 tax credit consumers would get was eliminated. With the passing of the Inflation Reduction Act bill, this credit is reinstated for all EVs with a manufacturer's suggested retail price (MSRP) under $55,000 for sedans and $80,000 for trucks and SUVs.Additionally, 50% of battery parts and 40% of minerals must be sourced from the U.S. or a country with which it has free trade.
As far as the cost of a vehicle, the Tesla Model 3 and Model Y qualify for this credit in lower trim packages.This catalyst could help Tesla maintain sales in two of its products, as consumers won't be enticed to purchase a different brand just because of a $7,500 discount. However, it remains to be seen if Tesla can meet the mineral and battery part requirements, as that information hasn't been released to the public.
Tesla still needs to stay on its toes
Although Tesla may be succeeding now, it must stay agile and innovative. Tesla's biggest task is releasing its electric truck, as trucks have long topped the U.S. sales charts. In 2021, the big three automakers sold 1.8 million new trucks in the U.S. That's a massive market that only Rivian (the R1T), Ford (the F-150 Lightning), and GM (the Hummer EV) have tapped so far. Farley even took a jab at Tesla's CEO Elon Musk in a press conference by claiming the Lightning is the leader of all EV pickup trucks and following that statement up with: "Take that, Elon Musk." By the time the Cybertruck hits the market (projected sometime in 2023), it's likely that GM, Ram (Stelantis), and Toyota will either have their own EV truck offerings released or be taking orders. With the delays in getting the Cybertruck to market, Tesla has lost the first-mover advantage that benefited it with other EV models.
Image source: Tesla.
There's also the issue of Tesla's expensive stock. With a $940 billion valuation, Tesla is the fifth biggest company in the U.S. by market cap. That value is just under 10 times larger than Ford ($65 billion) and GM ($58 billion) combined.
How can one company in the same industry be worth so much more despite bringing in less revenue? For the same reasons outlined above: Margins, opportunity, and market leadership. I'm not going to claim Tesla's stock is reasonably valued -- it's expensive. However, as Tesla ramps up its production capacity (as of Q2, it was 1.9 million annual vehicles versus 1.05 million in Q2 last year) and sees its supply chain issues ease, its profits could rise significantly from here.
In first-quarter 2022, Tesla delivered a 19.2% operating margin. This number dropped to 14.6% in Q2 due to China's COVID lockdowns and supply issues. If Tesla consistently maintains a nearly 20% operating margin and does it with increased production, its 108 times price-to-earnings multiple will quickly fall to a more reasonable level because of greater profits or maintain its high earnings multiple but see a large stock price movement.
The burning question remains: What is a reasonable valuation for Tesla stock? A high margin (25% in Q2), luxury business like Ferrari trades at 38 times earnings, and legacy automakers like Ford and Toyota trade at five and ten times earnings, respectively. In the long term, a PE ratio of around 20 seems reasonable, but that is when Tesla is a mature business and not growing rapidly, which could be years or even a decade. For now, investors must make a personal decision if the stock is too expensive or forget about valuation and focus on the long-term prospects. It's not an easy choice, but many of the stock market's biggest winners have seldom looked cheap.
Tesla isn't a stock to purchase if you want to make a quick buck. Instead, investors should be focused on Tesla's long-term potential in the shift to EVs. I believe the company is well positioned to compete against new EV offerings and could solidify its industry leadership with a few key product launches.
