Tesla Motors' (TSLA 2.28%) CEO Elon Musk believes that with the help of its planned more-affordable fully electric vehicle and its upcoming Gigafactory lithium-ion vehicle-battery production plant, Tesla can sell 500,000 cars per year by 2020. But many investors have flagged his vision as a pipe dream. After all, electric vehicles, or EVs, are only a fraction of the market, so there's no evidence that demand for a lower-cost Tesla vehicle would be sufficient to drive such significant sales -- right? Even more, won't well-capitalized, highly experienced competitors stomp all over Tesla when they join the EV race? For answers to these questions, buckle up for an in-depth look at the company's record so far and its future place in the EV industry.

Tesla factory in Fremont, California. Image source: Tesla Motors.

Tesla is betting big on Model 3
In August 2006, just before the recession, Musk published his "secret master plan" for Tesla. In his own words, Musk summarized the plan like this:

  • Build sports car
  • Use that money to build an affordable car
  • Use that money to build an even more affordable car

Importantly, Musk noted each subsequent decrease in price should drive higher sales volumes.

"The strategy of Tesla is to enter at the high end of the market, where customers are prepared to pay a premium, and then drive [down-market] as fast as possible to higher unit volume and lower prices with each successive model," Musk explained.

For the most part, Tesla has stuck to this plan. The Tesla Roadster became available in 2008. Priced above $100,000, the Roadster was an expensive two-door demonstration of what electric cars can do, and it helped fund the development of the company's next vehicle: the Model S.

The four-door sedan was aimed at proving electric cars can not only compete with, but be better than comparably priced gas-powered cars. If the vehicle's accolades to date are the measure of whether Tesla achieved this, it certainly did.

Model S. Image source: Tesla Motors.

But the Model S wasn't exactly affordable. With deliveries beginning in 2012, Model S initially had a starting price of about $60,000 (until Tesla said insufficient demand for its planned 40 kWh battery pack led the company to stop production of the entry-level battery, leaving the lowest-priced Model S at $69,900 for the 60 kWh version).

Tesla is now moving to the third stage of its plan. This "even more affordable car" is dubbed the Model 3. With it, Tesla wants to finally bring a compelling fully electric car to the masses.

As Tesla continues to sell Model S and preps its Model X sport utility vehicle for a production ramp-up, the company is already laying the groundwork for Model 3. Aiming to price the vehicle at $35,000, Tesla hopes the car will appeal to hundreds of thousands of consumers. With plans to launch the vehicle in 2017, the car is one of the main reasons behind Tesla's under-construction $5 billion Gigafactory, which is set to begin electric cell production next year.

Given Tesla's nearly $34 billion market capitalization, and with the company currently selling about 10,000 vehicles per quarter, investors are clearly depending on the Model 3 to be a major success. Failing to sell hundreds of thousands of cars by the end of the decade and millions by 2025 would make Tesla stock grossly overvalued at today's prices.

This raises the question: Is Tesla's vision for selling 500,000 vehicles per year by 2020 only a pipe dream? Or does a close look reveal it might be more realistic than critics suggest?

The path to 500,000
Piecing together commentary from management, investors can get some idea of how Tesla might go about reaching 500,000 vehicles per year.

It will mostly depend on Model 3.

Sure, sales of Tesla's premium-priced vehicles look set to grow beyond 2014 levels. Not only does Tesla aim to sell 50,000 Model S units this year, but Musk believes demand for its Model X SUV will rival demand for Model S. In other words, it's possible as many as 100,000 of these 500,000 in deliveries could come from sales of Tesla's luxury vehicles. But this still leaves about 400,000 vehicles before Tesla arrives at 500,000 in annual sales.

Data for 2012, 2013, and 2014 retrieved from respective annual SEC filings. Years with asterisks indicate estimates based on forecasts and comments from management, as well as extrapolation from this commentary by author. Chart source: Author.

But when the Model 3 goes on sale, will it create sufficient demand to fill that gap?

There is risk to any prediction -- particularly when it comes to projections based on huge growth rates. But a close examination of current demand for Tesla's vehicles suggests Musk's ambitious vision may not be as far-fetched as it would first seem. Here are three reasons.

1. Sales of long-range EVs are soaring. Many observers of the EV market lump together hybrids, plug-in hybrids, short-range EVs, and long-range EVs into a single category. This is a huge mistake. Since some of these categories are growing at significantly slower rates than others, doing this dramatically understates the trajectory of demand growth for compelling EVs.

To understand the current state of the EV market that applies to Tesla's vehicles, irrelevant vehicle types often included in analyzing EV sales must be identified and discounted. Sure, hybrids, plug-in hybrids, short-range fully electric vehicles, and long-range fully electric vehicles are all greener alternatives to internal combustion engine vehicles. But just because they share this characteristic doesn't mean they should be evaluated in a single category. Instead, consider each of these subcategories individually, with a focus on their respective value proposition:

Conventional hybrids are so far removed from fully electric vehicles that they would be better off included in the traditional internal combustion engine vehicle category. With no way to plug in and charge, this vehicle type still requires owners to visit a gas station every time they run low on fuel, eliminating the option to charge at home and run the vehicle solely on a battery and electric motor. While conventional hybrids are rarely included in an analysis of the EV market, it's important to realize how irrelevant this vehicle type is to the market that applies to Tesla.

Plug-in hybrids are essentially EVs required to cart around a giant gas-powered generator.

Short-range EVs, which I'll define as fully electric vehicles with 100 miles of range or less, are made for short-distance driving. Many of their owners will opt to drive fuel-burning vehicles when traveling longer distances.

Long-range EVs, which I'll define as those with 200 miles or more of range, fall in an entirely different category. These vehicles offer electric-motor acceleration, faster charging (because a larger battery can handle a faster charge), and complete freedom from gas stations. Furthermore, most drivers travel fewer than 200 miles in a day, so these electric vehicles can generally be charged at home rather than at a charging station. And since drivers travel more than 200 miles in a day far less often than they travel fewer than 100 miles in a day, the number of electric charging stations required to support these vehicles when traveling is a fraction of what would be required to support short-range fully electric vehicles.

When viewed in terms of the value propositions each type of "green" car offers consumers, long-range EVs are clearly in their own category.

Only one EV currently fits the definition of a long-range EV: Tesla's Model S. Because of that, the Model S is the best and only indicator of the demand for long-range EVs.

So how is the market for long-range EVs looking? Despite the Model S' now $75,000-plus price tag, sales are soaring, up 56% in Tesla's most recent quarter. This is not just an isolated moment of growth: The company believes it will achieve this same growth rate for the full year.The bullish demand story for long-range EVs has been consistent since the Model S first went on sale in 2012.

Data for chart retrieved from Tesla quarterly SEC filings for quarters shown and each quarter's respective year-ago quarters. Chart source: Author.

Furthermore, if the Model X, which Tesla plans to begin delivering this year, captures the same sort of attention among comparably priced SUVs, this growth rate for $75,000-plus fully electric long-range vehicles could persist for another year or two. In fact, it already looks like this will be the case. Even with zero advertising and the production version of Model X yet to be shown off, Tesla has over 20,000 deposit-backed net orders on the books.

2. These soaring sales required no advertising spending. Tesla hasn't spent a cent on advertising to achieve its current sales growth. Test drives and word-of-mouth marketing have been enough to boost demand faster than the company can boost supply.

Inherent benefits, or perhaps even advantages, for long-range EVs compared to their gas-powered counterparts build a compelling value proposition -- enticing enough for the car itself to serve as the ultimate advertisement. The more Tesla vehicles there are on the road, the more people understand them, and the more sales rise.

Tesla management explained this word-of-mouth effect in a letter to shareholders in 2013. "As more people see our car on the road, take a test drive or talk with another Model S owner, more demand is created for our product. Demand exceeds supply, despite no advertising, no discounts and no paid endorsements."

3. Model S success makes a case for Model 3 success. Unfortunately, there isn't a lower-priced electric vehicle currently for sale that can help us predict the demand for Model 3. All lower-cost vehicles with electric powertrains fall short of either being fully electric or having the ability to entirely replace a gas car as the only household vehicle.

The only way to assess the potential for Model 3, therefore, is to examine the success of Model S at its price point and think about how this could carry over to a lower price point.

How's the Model S selling compared to its $75,000-plus peers? During the first quarter, the Model S was the top-selling vehicle in the high-end premium sedan segment for all of North America. Therefore, if the Model S' success is any indication of the sort of success a long-range EV could have at a much lower starting price, demand for Model 3 will likely be substantial.

Given the much larger addressable market for vehicles starting at $35,000 compared to the market for those starting at $75,000, it's certainly possible Model 3 could generate enough demand to sell hundreds of thousands of cars per year by 2020. Indeed, the addressable market for sedans at this lower price range is so much larger that a handful of auto manufacturers might sell hundreds of thousands of $35,000-plus long-range EVs per year and still represent only a fraction of the market. For perspective, BMW alone sold about 480,000 of its 3 Series BMWs (one of three of its sedans with starting prices in the range of Tesla's targeted price point of $35,000 for the Model 3) in 2014.

While it might be a tad naive to imagine this success carrying over proportionately to lower-priced vehicles in which the addressable market is much larger, it would also be ignorant not to see the company's success at the high end of the market as at least some evidence that a Tesla vehicle at half the price of Model S could be quite compelling.

Musk articulated this thought process during the company's annual shareholder meeting in April: "As we bring out new models, in the Model X -- in the SUV category, obviously -- and then more affordable cars, this bodes well for being able to replicate this share for Tesla in other product segments."

Tesla's choice of making an all-electric car with the battery across the floor of the vehicle is completely unique in the auto industry. For now, Tesla is in a class by itself when it comes to building long-range EVs compelling enough to replace their gas-powered counterparts. Formidable competition in the space could spur greater interest in the category and accelerate a larger transition to Tesla-like vehicles. Image source: Tesla Motors.

4. Long-range, electric competition might benefit Tesla. Finally, and perhaps most important, it's quite possible that competition from other auto manufacturers could actually benefit Tesla. Sure, the introduction of competing electric long-range vehicles might sway some potential Tesla buyers to alternative brands, but if the competing brands make just-as-compelling electric vehicles, the same word-of-mouth and test-drive marketing that is driving demand for Tesla's cars could have outsize benefits on the total number of people interested in buying a Tesla-like vehicle. In essence, the entrance of formidable competition would accelerate demand growth for the whole segment.

So, are Musk's ambitions for Model 3 realistic? Quite possibly. But given the many uncertainties in the equation, investors should still categorize Tesla's big predictions as speculative. Not only is it possible that competing auto manufacturers will snap up a good portion of Tesla's upside, but there are always production risks for the company, notably given that it has never produced a vehicle at volumes even close to hundreds of thousands per year.

But investors who own the stock and are considering selling because of its very forward-looking valuation should think twice. The small but optimistic beginning of long-range electric vehicles is looking quite promising. And Tesla is positioned right smack in the middle of this fast-growing opportunity.