No matter how you slice it, Tesla (TSLA +0.91%) stock looks wildly overvalued by traditional financial ratios. While I've argued that the company has some game-changing intangible assets that you won't find on its financial statements, this doesn't mean they are not already priced in. After a 650% run-up in the past two years, you can bet the market is pricing in a rosy future for the company. So, is the stock overvalued, or not? The answer may surprise you.
Image source: Tesla Motors.
Potential sales
A closer look at Tesla reveals that the market's rosy outlook for the company may be justified. The electric-car maker already has a plan to build a Gigafactory to help it achieve the battery cost reduction needed to support its planned lower-cost car. And if sales of the Model S at its premium price point are any indication of how a less costly version of the vehicle will sell at its price point, Musk's aspirations for 500,000 vehicles per year by 2020 doesn't sound too unrealistic.
Sales in the coming years could look something like this.
Source: Tesla press releases and comments from management, particularly those of Tesla CEO Elon Musk in an interview with Automotive News earlier this year.
Even as early as next year, Tesla should surpass 50,000 deliveries. How? By the end of 2014, Tesla expects to reach a production rate of about 1,000 cars per week -- that's 48,000 vehicles per year. This would launch the company into 2015 at a rate that nearly doubles the 600 per week rate that Tesla started 2014 with. Further, various comments from earnings calls and quarterly letters to shareholders suggest the company is expecting Model X (due early next year) demand to actually exceed Model S demand. And these comments aren't void of reason; Tesla has been taking preorders for the Model X for several years now, giving the company plenty of time to gauge demand.
Going out a bit further, continued global expansion and further production gains make 100,000 deliveries of the Model S and Model X combined look like a realistic target by the end of 2016 -- that would put Tesla one fifth of the way to its 500,000 target before the third-gen, lower-cost Tesla is even launched.
Getting to 500,000 vehicles per year by 2020, of course, isn't as certain as the growth to come in the next several years. The further out we look into the future, the more things there are that could potentially go wrong.
But is 500,000 Tesla sales per year by 2020 really a moon shot? After all, Tesla is going to build the Gigafactory whether the rest of the auto industry likes it or not, and the raving reviews and ecstatic owners of the Model S suggest that a $35,000 Tesla could be a blockbuster hit. With the Model S currently outselling every other comparably priced vehicle in North America, imagine if the same fact holds true for the lower-cost car.
Tesla's planned Supercharger locations by 2015. Before the Gen III launch, Tesla is on pace to have 98% of the U.S. population within range of a Supercharger, making long-distance travel possible for just about anyone in the U.S. Image source: Tesla Motors.
So, maybe 500,000 deliveries per year by 2020 is possible. But has Tesla's $30 billion market capitalization already priced in this potential?
Not all sales are created equal
While we could stop here and calculate an average selling price for vehicles at the 500,000 level to see what the price-to-future sales ratio would be, that wouldn't factor in Tesla's uncanny ability to generate a lucrative gross margin.
Tesla says it can achieve a gross profit margin of 28% by the end of this year. This already puts larger automotive peers like General Motors and Ford, at 10% and 14%, to shame.
But will Tesla's gross profit margin fall as it introduces a lower-cost vehicle? Not necessarily. Going forward, Tesla will likely be able to maintain this gross profit margin -- even through 2020. Several factors should contribute to this outcome:
1. Reduction in battery costs. While journalists usually cite Tesla's plan to cut battery costs by 30% with the Gigafactory, this stops short of the cost reduction potential. It's likely that the cost reduction achieved with the Gigafactory will actually exceed 30%.
For instance, Tesla CEO Elon Musk said during the company's annual shareholder meeting last month that a 30% reduction is "probably conservative at this point" and that he thinks Tesla will do better than that. He even said that its battery supplier, Panasonic, now believes Tesla's stated cost reductions can be achieved.
Rendering of Tesla's planned Gigafactory. The company plans to produce more lithium-ion batteries per year by 2020 than the entire world's production in 2013. Image source: Tesla Motors.
Further, Tesla said it is planning for a cost reduction in battery pack cost that exceeds 30% by 2017 -- the first year of gen III volume production ramp; yet it isn't until 2020 that Tesla expects to reach 500,000 vehicle deliveries per year. In other words, by 2020, battery costs may have been reduced far beyond 30%.
2. Pricey vehicles. Sure, the company will be introducing vehicles with lower price points, but the lower-cost car will still have a meaningful average selling price. Consider the Model S. Despite its $70,000 starting price, the average selling price is $110,000, thanks to battery upgrade options and a host of other add-ons. It would be fairly conservative, therefore, to estimate an average selling price of $49,000 for the third-gen vehicle even though it will likely start around $35,000.
For the sake of conservatism, however, it would be best to forecast Tesla's gross profit margin to come down a bit by 2020 given that lower-cost vehicles may constitute more than half of the company's sales. Even after significant battery cost reductions and scaled operations, a meaningfully lower average selling price could drive Tesla's gross profit margin down a few percentage points.
Tesla stock may be priced more reasonably than it appears
So, how could Tesla's gross profit turn out in 2020? At 500,000 vehicles, an average selling price of $66,500, and a gross profit margin of 25%, Tesla could generate $8.3 billion in gross profit. In other words, Tesla could have about half of General Motors' current gross profit on less than a fourth of its sales. That would put Tesla stock today at about 3.5 times its 2020 estimated gross profit. How does that compare to Ford and GM? Respectively, Ford and GM have price-to-gross profit ratios of 3.3 and 3.5.
Of course if Tesla pulls off this sort of growth by 2020, the market will almost certainly award the stock a far higher price-to-gross profit ratio than the combined 3.4 pegged to Ford and GM today. Even more, a 3.4 price-to-gross profit ratio for Tesla would be downright ridiculous if Musk's aspirations for building several more factories around the world and reaching several million deliveries per year further out into the future still hold true. If Tesla really does execute as planned, a price-to-gross profit ratio of at least seven in 2020 would be realistic.
Where would this put the stock price in 2020? Making room for 15% share dilution, perhaps somewhere around $400. That's about a 9% return from today's price at about $240.
Model S. Image source: Tesla's official Twitter feed.
And to illustrate the potential upside over the longer term, keep in mind that 500,000 vehicles is far lower than where Tesla could end up. And even if Tesla reaches two million annual deliveries by 2025 or so, Tesla still would only account for less than 2% of an estimated 125 million global auto sales. So, even if electric cars are not the future, Tesla could simply dominate a niche and likely still provide value for shareholders who own Tesla stock today. But if electric cars do end up becoming a big part of the future, Tesla investors may be in for much more than a 9% annualized return.
To buy or not to buy?
With so many forward-looking assumptions priced into the stock, it may be too speculative to buy shares today. While Tesla's business may surprise to the upside in the coming years, it could also underperform. And underperformance when a stock is priced for results so far out into the future could have a very leveraged and not-so-fun negative impact on the stock.
