Tesla (TSLA -0.70%) has been among the best-performing stocks in the last five years, delivering a mind-blowing 861% return to investors.
The stock has come under tremendous pressure in recent weeks after the electric vehicle (EV) manufacturer reported a disappointing quarterly result. The bears are concerned about several challenges Tesla faces, while the bulls are considering buying Tesla's stock to take advantage of the price correction.
An analysis of the situation suggests the bulls could be making a wrong move here. There are at least two reasons why.
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1. Tesla will face enormous challenges in the coming quarters
Tesla delivered world-class performance over the last few years. Between 2018 and 2022, revenue from the sale of EVs surged 279% from $21.5 billion to $81.5 billion, and the bottom line improved from a net loss of $976 million to a profit of $12.6 billion.
While Tesla's past performance offers glimpses into its future, it does not guarantee its future results. On the contrary, the upcoming quarters look increasingly challenging for Tesla and its automaker peers.
One reason for that is increased concerns over the last few months about the economy. Consumers challenged by elevated inflation rates for the past 30 months as well as increased interest rates enacted to tamp down inflation are finding it more difficult to make large purchases. For example, the average 30-year fixed mortgage rate just touched a high of 8%, a level not seen since 2000. The higher interest rate tends to result in lower disposable income, affecting consumers' appetite to spend on high-priced items like cars.
Along with the economy, there are also ongoing geopolitical problems related to the Ukraine war, trade tensions between the U.S. and China, as well as the recent Israel-Hamas war. All three negatively impacted global economics and consumer sentiment. With so many uncertainties, consumers have good reasons not to overcommit on spending, especially on durable goods.
Tesla's recent result shows early signs of weakening consumer demand for cars. In the third quarter of 2023, Tesla's EV sales were 435,059, down from Q2 sales of 466,140. That drop came despite Tesla cutting vehicle sales prices in the last few quarters. Some analysts wonder whether the sales total would have been even lower had Tesla not reduced the selling price.
Tesla's profitability also contracted massively in the latest quarter, with gross profit falling 22% year over year, operating profit declining by 52%, and free cash flow contracted by 74%. These numbers suggest the company will have a difficult period in the coming months.
2. Tesla's stock is too expensive
Tesla has managed to generate consistent, solid performance over the past few years. The company's plans also suggest a promising future thanks to its investment in emerging and growing industries like autonomous vehicles, renewable energy, and robotics. As a result, the bulls tend to be very optimistic about the company. But a reality it seems they tend to ignore is the fact that the company is still predominantly an automaker. Roughly 84% of Tesla's revenue comes from selling cars, and the bulk of its services and other revenue (about 9%) are related to its car business in one way or another.
And herein lies the problem. Tesla's stock trades at a valuation comparable to the leading technology companies and not the automakers. For instance, Tesla's P/S ratio of 7.7 is higher than Alphabet's P/S ratio of 6.3. Other automakers like General Motors and Ford Motor Company have P/S ratios of less than 0.3.
Compared to other automakers, a significant amount of Tesla's valuation is tied to its ability to deliver on its future promises. That makes it more vulnerable to investor sentiment changes. If it fails to meet investors' high expectations, investors will be quick to rerate the stock to a lower valuation.
With a huge valuation gap to its peers -- traditional car manufacturers trade at less than 5% of Tesla's P/S ratio -- the downside risk is real and significant.
It's best to stay away from the stock for now
There are clear signs that Tesla is heading toward a challenging period in the coming quarters. Sales volume could deteriorate further, and the company may see more pressure on its profitability. Worse, the stock is still priced for perfection, suggesting investors have yet to realize the risks ahead.
If and when Tesla's performance deteriorates further in the coming quarters, its stock price could fall further to reflect the new reality. For conservative investors who do not want to be caught up in such volatility, it's best to avoid the stock altogether.
