Wednesday, September 4, 2013

Valuation of the week 1: A Tesla Test

I taught the first session of my valuation class, that I previewed in my last post, today. As part of that class, I do what I call a “valuation of the week”, where I pick a company and value it and then post both my valuation (with the spreadsheet and the raw data that I used) and a shared Google spreadsheet for anyone who wants to take my valuation and make it their own (by changing the assumptions). I do this for two reasons. First, I believe that you learn valuation by valuing real companies in real time, not by talking about valuation or reading about it. Second, from a purely selfish standpoint, I pick the companies that I find interesting as potential investments or as real world case studies for my valuations of the week. I find the “crowd valuation” that emerges from this process to be useful in reassessing my own valuations.

As my first valuation of the week, I picked Tesla, for three reasons. First, as a technology company in an otherwise capital-intensive, mature business (the automobile manufacturing business), it stands out. Second, the company has a charismatic CEO, Elon Musk, an ambitious man (and I don’t mean that in a negative sense) with a great deal of imagination. Third,  the stock has taken off in the last year, up more than 500%, fueled by both positive news on the product front as well as on the financial front (increasing revenues, declining losses, paying down of debt). 
At its current stock price of $168.76/share, the market capitalization for the company is more than $20 billion. The question for investors, both in and out of the stock, is not whether the company was a good investment over the last year (of course, it was) but whether it is a good investment today. You can download the most recent annual and quarterly reports for the company.

Using the standard metrics, the company seems  over valued. With revenues of $1.33 billion and an operating loss of -$217 million over the last twelve months, it seems absurd to attach a value of more than $20 billion to the company. At close to 15.4 times revenues, Tesla is being valued more like a young technology company than an automobile company. However, these standard metrics are also often misleading with young companies, since value should be driven not by revenues and earnings today but by expectations for these values in the future.

Expected Revenues
For Tesla to be able to deliver value as a company, it is clear that it has to scale up revenues. On the good news front, the company has had a good year, with the revenues in the first six months of 2013 of $956 million representing a surge from revenues of $41 million in the first six months of 2012. While growth will get more difficult as the company continues to become larger, the question of how difficult cannot be answered until we define the potential market for the company. If we define it narrowly as electric/hybrid cars, the market is small (even though it is growing) and the potential revenues will have to reflect that. If we define it more broadly as the automobile market, the market is a huge one and Tesla’s potential revenue expands accordingly. 

Since the line between electric, hybrid and conventional automobiles is a fuzzy one, which will get fuzzier over time, I will take the view (optimistic, perhaps) that Tesla is an automobile company that happens to specialize in electric cars and measure its potential revenues by looking at the biggest automobile companies today. 

Based on revenues, the biggest companies are those that offer the full range (from luxury to mass market) of automobiles. It is true that BMW and Daimler make the top ten list, but they sell far more than just luxury cars. In valuing Tesla, I am going to assume (and I am sure that some of you will disagree) that success will bring them revenues close to those delivered by a company like Audi ($64 billion). While it is conceivable that Tesla’s revenues could approach those of the auto giants ($100 billion plus), I think the revenue growth required to get to those levels would be incompatible with the high operating margins that I will be assuming for Tesla. Assuming that Tesla stays making just electric cars, this forecast is an optimistic one, insofar as it assumes a rapid expansion in the electric car portion of the automobile market.

Profitability
The second piece of the puzzle in Tesla becoming a valuable company is that it has to become profitable. Based on the reported loss of $216.72 million over the last twelve months, the pre-tax operating margin for the company is -16.31%. It is true that this paints too dire a picture of the company because the company did spend $306 million in R&D over the same twelve month period. Assuming a three-year lag, on average, between R&D expenditures and commercial payoff, and capitalizing R&D does reduce the operating loss to about -$21.86 million (resulting in an after-tax operating margin of -1.64%).

To get a sense of what the Tesla's operating margin will be, assuming it makes it as a successful company, I estimated the pre-tax operating margins of all publicly traded automobile companies globally, dividing the operating income from the most recent 12 months by the revenues over that period for each company. Since automobile companies have volatile earnings, I also computed a normalized pre-ta operating margin for each company by looking at the aggregate operating income over the last decade, as a percentage of aggregate revenues over that period. The distribution of the both measures of operating margin (the 2013 value and the average from 2003-2012) is shown below:

Note that the sector has low pre-tax operating margins, with the median value of less than 5%. Companies at the 75% percentile generate margins of between 7.5% and 8.5% and there are a few companies that generate double digit margins.  One of the outliers is Porsche which reported a pre-tax operating margin of close to 16% in 2013, though its ten-year aggregate margin is closer to 10%. You can download the dataset that includes the key numbers for all auto companies by clicking here.

For Tesla, we will assume that its focus will continue to be on high-end automobiles and that is margins will converge towards the higher end of the spectrum. In fact, I am assuming that the technological and innovative component that sets Tesla apart will allow it to deliver a pre-tax operating margin of 12.50% in steady state, putting it in the 95th percentile of auto companies (and closer to the margin for technology companies). I will assume that the margin improvements occur over time, with the biggest  improvements happening in the near years. The figure below captures the forecasted operating income and margin, by year, in my valuation of Tesla:

Based on my estimates, Tesla will generate more than $8 billion in operating income by year 10, making it more profitable than all but three other automobile companies today (Toyota, Volkswagen and BMW). 

Investment Requirements
Growing revenues roughly sixty fold and improving operating margins to match the most profitable companies in the sector will require reinvestment. Some of it will take the form of additional R&D, as Tesla tries to keep its competitors at bay, and some of it will have to be in more conventional assembly lines and factories, as production gets ramped up. Over time, I believe that the latter component will come to dominate the former.

In my forecasts, I have assumed that Tesla will have to invest about a dollar in capital (in either R&D or plant/equipment) for every additional $1.41 in revenues. That matches the industry average of the sales to capital ratio of 1.41 for US companies. Since the sales to capital ratio for technology companies is higher (2.66), it is possible that I am over estimating Tesla's reinvestment in the early years. However, the return on invested capital that I obtain for Tesla in steady state (in year 10), based on my estimates of operating income and invested capital, is 11.27%, putting it again at the top decile of automobile companies.

Risk
Tesla is undoubtedly a risky investment and there are three components of risk that I attempted to incorporate in the valuation:
a. Business/ Operating risk: Tesla is exposed to substantial business risk, some coming from macro economic sources (the strength of the economy, inflation, interest rates), some resulting from technological shifts (the winning technology in the electric/hybrid auto business is still to be determined) and still more emanating from the sector (with every major automobile company staking out its claim on this segment of the business). To capture the risk, I assumed that Tesla, as it stands now, exposes investors to a mix of automobile business risk and technology business risk. While I assumed a 60% auto/40% technology mix in arriving at a cost of capital of 10.03%, the value per share that I obtain is not very sensitive to this assumption:


Treating Tesla as a purely automobile company increases its value to about $74.73, whereas treating it as a technology company lowers the value per share to $60.84.
b. Geographic risk: While it is likely that as Tesla grows, it will have to look to emerging and more risky markets, I will assume that its risk exposure for the next decade will come primarily from mature markets, allowing me to use my current estimate of the equity risk premium for the US of 5.8% for the cost of equity/capital computations. 
c. Truncation risk: Tesla, in spite of its lofty market capitalization and recent successes, is still a young, money-losing company. A large shock to its business (from a legal setback, a recession or a sector-wide slowdown) could put the company's survival at risk. While that risk has declined substantially over the last two or three years, I think that it still exists and will attach a probability of 10% to its occurrence. If the company does fail, I will also assume that it will lose a significant portion of its value in a distress sale (receiving only 50% of estimated value).

Loose Ends
As with any young company, there are loose ends to tie up that affect value. In particular, I would point to the following:
a. Subsidized debt: Tesla was the beneficiary of subsidized loans from the DOE, amounting to roughly $465 million. While this loan loomed large two years ago, when Tesla was a smaller company with more default risk, it has faded in importance partly because of Tesla's success (and the resulting access to capital markets). Since Tesla has paid down the loan, it no longer has any effect on value.
b. Net Operating Loss carry forward: At the end of 2012, Tesla had a net operating loss of just over a billion that it is carrying forward. I used the NOL to shelter income from taxes in the early forecast years, pushing up cash flows in those years. As a consequence, Tesla's income is sheltered from taxes for the first six years of forecasts.
c. Management/Employee Options: Of larger import are the management/employee options that Tesla has been generous in granting in the last few years. As of the most recent 10K, the company had approximately 25 million options outstanding, with an average strike price of $21.20 and 7 years left to expiration. Since there only 121.45 million shares outstanding, the value of these deep in-the-money, long term options represents a significant drag on value.

The Bottom line
The ingredients that make a young, money-losing company into a valuable, mature company are no secret: small revenues have to become big revenues, operating losses have to turn to profits, there has to be enough reinvestment (but not too much) to make these changes and the risk has to subside. I am assuming all of these at Tesla but my estimated value per share of $67.12 is well below the market price of $168.76. You can download my valuation spreadsheet by clicking here.

Is the value sensitive to my assumptions? Of course, and especially because Tesla is a young company in transition. In fact, replacing my point estimates for the input variables (revenue growth, target operating margin, sales/capital, cost of capital) with distributions yields a distribution of value for Tesla that reflects my uncertainty about the future:

Note that there are scenarios where the value per share exceeds the current market price ($168.76), but I would add two cautionary notes. First, at least based on my estimates, the probability that the value exceeds the price is small (less than 10%) Second, the combination of outcomes (high revenue growth, high margins and low risk)  that would yield these high values are difficult to pull off. 

You can accuse me of being too pessimistic in my assumptions, but the narrative that underlies my valuation is an optimistic one. I am assuming that Tesla will grow to be as large as Audi, while delivering operating margins closer to Porsche's. Even with these assumptions, I cannot see a rationale for buying the company at today's market price but that is just my personal judgment. You are welcome to disagree. In fact, if you download my valuation and change the key assumptions, please take a minute to report your estimate of value per share in this Google shared spreadsheet. Let's see how the crowd valuation plays out!

93 comments:

Anonymous said...

so you're saying the stock is worth just 1x projected operating profit in 2023? that seems pretty cheap.

Joel said...

You might want to read Tesla's business plan before attempting to do a valuation analysis.

Tesla is in two markets today: high-end, low-volume sports cars ($100K) and high-end, medium-volume sedans ($50-100K). It has only entered the latter recently so it's volume is not high yet, but that market is a mid-volume segment. However, their third act will be lower-end, high-volume sedans ($25K), sometime within the next few years assuming continued successful business execution.

The company's valuation is based both on the latter low-end market and on the long-term viability of their technology. The market believes that Tesla has gotten electric cars right while their competitors still struggle to achieve similar travel range, etc. Additionally, Tesla is betting that the car market will increasingly be electric cars within 10-20 years, that using fuel-based transporation will be the exception and not the norm.

In the long run (20+ years) I think there is little doubt that Tesla is right about the future of cars. Our energy production will need to be derived from such diverse sources that it will become too costly and too impractical to limit transportation to fuel-based engines. Sustainable energy consumption is a correct thesis, it's just the timing, adoption rate, and infrastructure issues that are unclear and may cast doubt on the success of Tesla over the next 5-10 years.

Anonymous said...

An excellent appraisal of the Tesla value proposition.
Regarding competitive risk, there is a company (not public yet) called Via that has a compelling hybrid technology that delivers almost all of the energy savings of Tesla's all-electric motor with a gas-based charging motor that extends the range dramatically. Something like the equivalent of 100+ mpg.
This could be a real challenge to TSLA's valuation.

Vivek Gujrati said...

Sir,

I believe you are too optimistic about margin front.

The Excel spreadsheet share by you contain normalized margins of both two wheeler and four wheeler companies and If I remove two wheeler companies margin median margin of four wheeler companies are around 6% while highest margin is around 12% in four wheeler space.

I am not able to understand why you are comparing Telsa with technology companies. I agree with your point about innovation. But there are some companies which are already there in this segment (like Toyota.)

Telsa success story will lead to bring more competition in the sector which ultimately bring the margin with the same as peer.

Rgds,

Vivek Gujrati

Anonymous said...

Good analysis but to my mind over generous. Assuming that Tesla grows to the same size as Audi is wildly optimistic. That they will able to penetrate markets like Europe who are far more conservative when it comes to buying cars and are generally far more biased to their home car manufacturers. ie go for a drive in Italy, Germany, France and you get a good idea. Also foreign markets are far less susceptible to the Elon Musk/Tesla hype that the US press has been stirring up. Also very little mention is made that competitors like BMW, Toyota etc etc will be likely to bring out competing technologies to a client base already familiar with their products.

Piyush said...

Before apple launched the iPhone, could you have predicted based on existing giants' margins, what the margin of the iPhone was going to be like or the MCap that apple would attain consequently. When a product has the potential to redefine industry standards, extrapolation is not a good idea. Agreed, its very very risky to buy a stock on hope, but positions can be taken through options when the moody markets offer you a decent buy.

Krystian said...

Dear Profesor,

One thing I am missing here is the addition of real options valuation- as Piyush mentioned- we need to assign value to a real option that Tesla will come up with a revolutionary product somewhere in the coming years. Just like Apple did and many other companies with such visionaries like Musk on their boards (eg Virgin). This is what people are paying for, cars could just be tip of the iceberg. I've seen you using real options in start-up valuations so we could also attempt that in this valuation.
Regards,
Krystian

Unknown said...

(A) your description of their target markets sounds a lot like Audi's, like he said
(B) time value of money (not to mention the nature of long-run economic profit) makes your view of the car market in 20+ years effectively meaningless, which seems to be the overarching concept here

Anonymous said...

Unable to view your lecture videos

Anonymous said...

Dear Prof. Damadoran,

I really like your analysis from a financial perspective. However I am missing the aspect of Product Lifecycle Management for the automotive industry. If it would be included you would come to much lower results.

Just a thought because one discipline cannot be viewed from one perspective only.

Regards,
Jack

choubb said...

to value Telsa is like to predict a 3 year kid . how many money he can own in his lifetime, especially the kid invent a new product or a new industry. Just imagine in 1980, would you imagine a Google ? and when Google listed public, how do you tell it from so many dot com bubbles.

Valuation method is only for mature industry, not emerging technologies.

UniverseofRisks said...

Great Post!. One point to be noted Tesla has grabbed contracts on providing electric drive train package for Daimler AG (Mercedes Benz). There is a good possibility that their capital requirements (manufacturing) might be much less if such contracts end up being a large part of its future revenues.

Alex Rasmussen said...

Professor I enjoy your posts and models very much.

Seeing as you are always trying to better the educational value of your content - just a little issue from my experience that would help a lot.

It seems that in the models you post that include option value sheets - the formula messes up on Mac's Numbers application. It seems almost everything else is ok but the option value, specifically Adjusted S, shows as an error when going from Excel to Numbers.

This leads the overall valuation to be $97 for Tesla when options are not taken into account.

Thanks in advance for hearing me out! If it's a problem on my end as opposed to the Excel --> Numbers translation then I would love to know.

Ravi Dawar said...

Prof.

Can you please explain how you reached the number for pre-tax operating margin for the company - -16.31%

I took the Loss from operations - (394,283) and the Total revenues 413,256 to reach a number of

(394,283)/413,256 = (95.40) %

Anonymous said...

enjoyed reading the post (even more so as I have built up a short options position in the name), I think it shows that even on generous assumptions it's overvalued by a factor of *2.5 (i.e. a niche car maker becomes an Audi .. in tesla's case rather than 'Vorsprung Durch Technik' its more a case of 'Vorsprung Durch Hei├čluft' lol).

the issue of guessing what will happen in the future with a young upstart company is of course an insolvable one, but my view is that tesla is being used as a canary in the coalmine by larger autos, they will watch how much traction tesla gets among the masses and slowly start developing their own lines of exclusively electric cars, tesla will remain a small niche producer perhaps selling 5-10 times the amount of cars it does now.

Anand

Anonymous said...

I would invest in MSFT if Bill was CEO, I would put all my money in Walmart if Sam was the CEO, same for APPLE if Steve was still alive, so this logic is simple and straight, investing in the guy who can make history, then having fun reading detail report(lots and long). These kind of guy does not show up all the time, especially in Elon's case, who would easily be one only in 50 years case.
In the end, it's the man to man competition, I just can not find another equivalent opponent in next dozens years, so you know where I will put my money.

Ted Lim said...

Hello Professor Damodaran,
I enjoyed the article and was taking a look at the valuation sheet and hope that you will read this and perhaps take a second look or build in another scenario. Assuming that you benchmarked against incumbent Automakers, I think the analysis needs to be revisited because of the time frame that is used in the analysis. While I (and Elon Musk) agree that the valuation of Tesla is "generous," I don't believe it's unjustified (at least not yet). I'm going to tackle this post in a two prong approach. You will also notice that I am driven largely on fundamentals and not heavily driven by corporate valuation at this time. I think the fundamental approach is the best way to go for a company that is trying to be innovative and is in the growth stage.
First I want to focus on execution. Looking at the past 12 months of data paints a very misleading image of Tesla. Aside from the fact that more cars are being delivered than estimated, I think what matters here is the Q1 and Q2 Gross Margin numbers which trended upward Q113 ~20% GM and Q213 ~25% (ex. ZEV Credits). Tesla Motors has called out their top risk: execution. Execution from the supply chain standpoint has been a nightmare for Tesla Motors for the following reasons:
1. Scaling production from ~400 cars/year with the Roadster to ~400 cars+/week. The sheer logistics and time frame of doing this in a year presents many difficulties.
2. Supplier constraints due to disbelief in Tesla's sales estimates and supplier "short cuts" taken. I want to point to a few costly hurdles that were experienced last year. “Frunk” liners got stuck at the Mexican Border due to a drug shoot out. USB Cables for the Model S were stuck at customs so Tesla had to buy USB Cables from Brick and Mortar outlets in the California area. Tires had to be flown in from the Czech Republic. There were issues with the Alcantara headliner for the first series of cars. I can go on and on. I wish I could say I had a financial analysis of the impact of this, but I really don't. But let's just call it a few BPS.
This point about the supply chain is crucial and I can't emphasize how important this is. You mentioned that the company is in its growth phase. There are growing pains which led Tesla to get "hit" from a margin standpoint. Management has taken notice of this and continuously works on this (evident with the performance cited above). Furthermore these margins are only going to improve as Tesla gets "less stupid" (words of Elon Musk) with the supply chain.
I also know for a fact margins are only going to improve because of the changes Tesla made in August. Prior to covering this change, we have to recognize one thing about Porsche that you mentioned. Porsche has a high margin on its products, not so much the car, but the options. Tesla's Model S in the beginning was very much bundled. Now it charges for options and had a price increase because certain people didn't want parts of the bundle. For example, owners had issues with Alcantara headliner (due to allergies). This is a high margin item which Tesla now charges for. Previously, a Carbon Fiber lip spoiler was included, now it's $1,500. I had to point out that this is another margin driver aside from regaining lost profits due to supply chain inefficiencies.
--Continued

Ted Lim said...

3. Inherent Advantage lies in Tesla. The majority of industry specialists think it’s ludicrous that there’s even mention of 25% gross margin for the year. For Tesla, is it really? If one does a parts explosion on any internal combustion engine vehicle they are going to see thousands of parts. If there is a parts explosion on the Model S, one will see significantly less. This is a huge advantage Tesla has over the incumbents who refuse to go the electric vehicle route and insist on hybrids. This can be the case for obvious reasons: lack of infrastructure for EV’s, conflict of interest (cannibalization), and lack of engineering prowess. I’m not saying that engineers at Toyota, Honda, GM, etc. are unintelligent; I’m just saying they don’t know rocket science and focus more on incremental changes instead of paradigm shifts.
My last point to ponder for you is the target market. You are correct in using Audi and other automakers as comparisons. Many “analysts” point to the Volt, Leaf, etc. which is entirely wrong (just drive the car and you will know). The Model S is competitor to a vast majority of the luxury cars out there. Granted, early adopters were a mix of those with a Prius, Leaf, Volt, etc—I’d argue this was not an expected outcome. What needs to be looked at is the potential slice of the following:
BMW’s 5,6,7 series market
Audi’s A6, A7, and A8
Lexus’ GS, LS
Mercedes E, S, CLS
Just taking a few percentage points of these markets are huge. But let’s look at projections 5 years out. In 2014/2015 what needs to be added are revenues for Model X which can capture the SUV market. Then what I think the stock is heavily valued on is the 2016 Gen 3 Car (Model E) which will capture the more mainstream 3 Series, C Class, and A4 kinds of vehicles. Tesla is aiming for ~250k cars a year on the Generation 3. NUMMI can accommodate this. It used to run production of ~500k cars a year and that’s without multitasking robots and heavy labor intensive assembly and vertical integration. While many do share your extremely conservative valuation of Tesla (namely the shorts crying), there are a few of us who see something much bigger potentially occurring which is what our valuations are based on-- Call it the “iPod” moment that many investors had with Apple.
I’ve written too much, but can go on more. I hope my thoughts of Tesla can lead to some thought provoking conversations and at least have you consider rethinking a few levers in the financial model.


Anonymous said...

"The second piece of the puzzle in Tesla becoming a valuable company is that it has to become profitable."

I agree. Based on this I would like Prof. Damodaran to pick AMZN for stock of the week.

I would like to see his valuation for AMZN given its slim operating margins.

Thank you in advance in case AMZN is picked one day and discussed like TSLA.

Aswath Damodaran said...

Excellent points in some of these posts and this is exactly the conversation I was hoping to get started.
First, the argument about Tesla targeting the battery business, rather than the auto business, is worth considering. While the potential revenue from this business will be smaller, it will require less investment and perhaps deliver higher margins. Second, Ted Lim's points about the pathway to potential success for Tesla is well thought through and viable. Ted, you clearly know the insides of this business better than I do.

Here is my only point. I think that even the bullish posts here are arguing that there is pathway to justify Tesla's current valuation. I don't disagree. I just think the pathway has a lot more barriers in it than the market is building in.

Thank you, though, for the thoughtful comments in the posts. And please do post your valuation of Tesla, with your considerations built in, on the shared spreadsheet. I have neither a crystal ball nor the monopoly on the truth.

Anonymous said...

The Audi comparison looks optimistic to me. I like to think in units sold. Tesla in comparison to German high-end makers:

Last year, BMW brand sold 1.54 million vehicles, followed by Audi with 1.45 million. Mercedes brand sold 1.32 million vehicles.

Read more: http://www.autonews.com/article/20130725/ANE/130729939/audi-likely-to-hit-1.5-million-sales-target-two-years-early#ixzz2e2mOi73y

Given that TSLA's current factory can only produce 500k a year, they would have to open two additional factories of the same size )for example, one in Asia and one in Europe).

Aswath Damodaran said...

Alex,
The reason the options spreadsheet fails in Numbers is because it requires iterative calculations that Excel allows but Numbers does not. There is no simple fix in the option spreadsheet, but you can use the treasury stock approach to incorporating option value. Just add the exercise proceeds from the options being exercised today to your overall equity value and divide by the total number of shares including options.

Aswath Damodaran said...

Ravi,
The operating margin is based on the trailing 12 month numbers. I think you are using the numbers from the last 10K.

Varadha said...

As a self-taught student of behavioural economics, I find the entire hype around Tesla much ahead of fundamentals.

It is still a car and does not change anything in the way people drive. Think about

- Switching costs - if GM/ford/toyota come up with a better car and under cut Tesla, will it be able to get a 16% margin

- Head room for growth - California is not a microcosm for the world market. Case in point, Toyota prius is still hardly popular in mid-west/texas etc.

- Importance of distribution/brand : As one moves down to the $ 25/50 k sedans, distribution and "brand awareness" become a lot more important.

- No significant trailing revenues : An iphone changed the revenue model significantly for the phone industry simply because it had a "long tail revenue" from content driven by high switching costs - from iphone apps, data plans, from telcos etc. I do not see that happening with Tesla.

- Headroom in international markets : I cannot even imagine Tesla getting sold in any of the BRICs countries except as a trophy car for people who have a lot of money to thrown around. Where is the volume going to come from Dearies ?

This, as always, looks like the bubble - Also, there is something I wanted to say that Warren Buffet had said at the peak of the dot com bubble when berskshire was hammered.

"Growth prospects in an industry do not equate to shareholder value creation. Think aviation, think automobiles over the last 100 years. The industry has grown 100 x and shareholders have lost their shirts, multiple times over."


It's going to be the same cycle :

- There is huge momentum and the wave rises higher and higher.

- The company misses one quarter of earnings badly. Then the momentum wave falls off a cliff

- Everyone turns extremely pessimistic and the stock loses 50-60% of the value over 2-3 quarters. Everyone starts doubting the future of Tesla

I can't imagine that someone is saying 1x operating profit in 2023 when it is at a revenue base of 60 x from today. Holy smoke !


To wind up with a quote from Charles Mackay from his ever famous book " Extraordinary Popular Delusions and the Madness of Crowds"


'Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.'

I am sure that there is enough momentum to carry Tesla through to another 20-30% price - then one missed quarter, one accounting change and it will all come crashing down. I expect a 30-40% erosion on market cap in 3-4 years, to be accentuated if there is a big macro event - Fed's QE drying up, bad GDP/unemployment numbers.

Anonymous said...

I probably shouldn't even be mentioning this, because as you said, "it has faded in importance". But you also said "Since Tesla has been paying down the loan"... Unless I am misunderstanding what you are saying, Tesla payed off the loan in full over a month ago...? Just thought you might want update that statment.
Garn

Anonymous said...

A question regarding operating margin assumptions:

In a very optimistic scenario, shouldn't Tesla be able to match or even topple Porsche's margins?

Because - unlike any other car company I'm aware of - TSLA sells DIRECT to consumers without intermediaries/dealers.

As Prof. Damodaran stated in his article, Porsche achieved close to 20% in very good years:

http://www.porsche.com/international/aboutporsche/pressreleases/archive2013/quarter3/?pool=international-de&id=581A41AC60363343C1257BB30042D67B

16 to 18% were possible for Porsche in recent years.

- - - said...

Thank you professor, appreciate the insight into Tesla.

One question: how does Tesla's unique distribution model (i.e., bypassing the traditional franchises) impact the valuation? Is there an opportunity for higher margins / revenues because of the direct to consumer model?

Seems like a comparison of Tesla against the franchise-based auto manufacturers would only be partially applicable.

Thanks!

-Mauricio

Jason DaCruz said...

Thanks for the note professor -- I tweeted you asking about TSLA a few weeks back!

What gives me anxiety about Tesla is that there's no easy way to determine their steady-state margin. I see three main businesses: premium auto, near-premium auto, and battery tech. Premium auto and -- this is where my limited knowledge of battery tech could hurt me -- their battery deals could provide higher profits. However, because of the high cost of Tesla's batteries and the consumer's unwillingness to accept a limited range, I think the near-premium market will leave Tesla with thinner margins than you have assumed.

Additionally, Tesla's charging station infrastructure, lease and warranty arrangements (isn't the latter 10 years?!), and limited spare capacity at existing factories gives me pause.

Lastly -- I see you've accounted for loan subsidies. How about the carbon credits Tesla's been able to sell?

rr said...

Another great post Prof. Damodaran.
The major issue I have what IMHO looks to be an optimist view, concerns the actual operational capability to bring to market in such short period of time the amount of cars needed to generate such revenue estimates.
I'm by no means a car industry expert so I would welcome informed comments on how many cars Tesla would need to sell to achieve $65B in 10 years time? Assuming average inflation of 2%/year, that's about $54B in today's dollars. How many cars did they sell in the last 12 months. (if we wish to be more "aggressive" lets multiply by 4 the number of cars sold in the last quarter). Where are they in terms of capacity utilization? What's their capex pipeline? How soon can they double current capacity? The Excel model assumes something they can do it on average every 17 months. What about distribution, can they handle doubling volume every 17 months? And things become even more complicated if we factor in that part (if not the larger part) of their revenues will come from low end segment (lower prices per car mean even more cars). I mean, they surely have a lot of technology DNA in them, but going forward it's the scalling of the industrial side of the company that will present the greatest challenge to fullfill the assumptions of this model. I just can't phantom what assumptions lie behind the current market valuation.
I really hope to get feedback on my questions.
Best regards
Ramon

rr said...
This comment has been removed by the author.
Unknown said...

All these comments on TSLA just goes to show how emotional people are in this name. If anyone is buying TSLA because of valuation, they are an idiot. It is purely a growth/momentum stock now and nobody knows where it will top out at. Just like AAPL, CMG, LULU, TASR, YHOO and all that have gone before it, once a stock hits momentum status it can go to the moon before crashing back down to earth. Just wait until you hear your mom, a bartender, or cab driver talk about buying TSLA. Then you'll know the end is near.

Calvin said...

Tesla Will have an operating margin of 25% by year end and that may improve over time.
The design allows for margin expansion.
Porsche had margin close to 50% before VW take over.
Tesla can match that over time.
You have assigned no value to intellectual property.
Tesla is years ahead in Battery technology, heat management, charging...
No value is assigned to first mover advantage in terms of the super charger stations.
Nothing for the innovation that resulted in best and safest car of the year.
This is analysis is quite incorrect. Frankly ridiculous.

rr said...

Calvin,
I come here to learn and you seem to be way ahead in valuing Tesla. Could you please share with the rest of us your model and its assumptions?
I must say Prof. Damodaran's analysis is the best I've seen so far.
Some interesting news I've read about it:
http://www.zerohedge.com/news/2013-08-26/tesla-crosses-20-billion-market-cap-twice-size-fiat

http://www.zerohedge.com/node/476466

http://www.zerohedge.com/news/2013-06-03/how-many-cars-must-tesla-sell-interactive-calculator-has-scary-answer

Looking forward to hear back from you.

Pierre Johnson said...
This comment has been removed by the author.
Smack MacDougal said...

Today, a share of Tesla sells for $169.93. That is what market participants say the capital structure of Tesla is worth.

If you are right and market players with real money down are wrong, then come forth and tell us exactly when TSLA goes to $67.12.

How much money do you have riding on this, talking shopper?

College professors and comedians. Can you tell them apart?

Anonymous said...

@Calvin: You are mixing up gross margins and operating margins for Porsche (and Tesla).

Please read up on difference between GROSS and OPERATING margins, thank you.

Anonymous said...

I disagree entirely with the professor's analysis. Tesla has been growing revenues rapidly primarily because: (1) it lacks any real competition (in the US market); as a result (2) its battery technology currently leads (the high end) electric market, a niche market at this point at best. If and when Tesla becomes a greater success, the market will expand and attract capital and competition. The auto market has, historically, been one of the most brutally competitive markets, with one manufacturer only fleetingly acquiriing a competitive advantage over others. Increased competition from the likes of BYD, GM, etc., (and from new players not yet even in existence) will create a competitive landscape, at this point, too difficult if not impossible to predict. In addition, there's no clear concensus that electric cars are superior to gas. In the 19th century, electric cars at one point composed a third of the car market and then faded into irrelevency. For the reasons above I venture to say, with all due respect, that the professor's analysis is dubious at best.

Ted Lim said...
This comment has been removed by the author.
Ted Lim said...

I am really glad you did the analysis. I haven't seen anything truly in depth for a long time. What is typically seen and covered are the unintelligible argument articles from Seeking Alpha, Fool, etc. Although I am a Tesla bull, I also know/seen enough to know when a bull turns into a pig.

To the point about Tesla targeting the battery business. I believe what the comment was pointing at was the Tesla powertrain business that is licensed to Toyota (for the Rav4 EV) and Daimler (for the Smart EV). The powertrain are the components in the Model S that make up the "skateboard"-- the Battery Pack, Chargers, Motor, Electronics Module, and Gearbox. Making all of these flow together is the bread and butter and what makes Tesla cars special. Here in lies Tesla's competitive advantage (along with their human resources). It's widely known BMW, GM, and the big automakers are buying the Model S and trying to "crack the code" in how Tesla makes everything work--namely its Supercharging capability that almost seem to defy thermal science.

Anyway, I digress. I concur with you on the point that Tesla has many hurdles to overcome before the full justification of the valuation, but I'd argue it isn't as far as you think. Last July I made the prediction and slapped a price target of $50 on TSLA. Clearly, Christmas came early with the Short Squeeze after Q1 because so many were betting on Tesla to go the same route as Fisker. Clearly unintelligible people that didn't do their homework. I got my $50 price target strictly based on my well founded speculation (not investing-- yet) which came from a few factors/expectations:

1. Tesla hitting targets of delivering ~3,000 or so cars by EOY 2012
2. Achieving a production run rate of 20K cars/year for 2013
3. Driving the vehicle (which led me to realize this was a special product)
4. Looking at the manufacturing processes
5. Researching the partnerships and capital infusions that were received from Panasonic/Toyota/Daimler-- Akio isn't one to take risks, but the man knows what he is investing in.

So clearly, my expectations were met. After the Q1 squeeze I debated exiting my long position. Then I thought about the secondary offering and my investment horizon. The secondary was an excellent move and led me to set more concrete targets. I am now 50/50 speculative and investing at this point in time. I firmly believe Tesla will see ~$200 a share by EOY 2013. Financially, I want to point out the price of the convertible note conversion of ~$184. This number sticks out in my head. Then there's the disclosure of what the capital is used for. There was indication of a significant ramp up of Capex, purchase of land next to NUMMI, and plant openings in Europe. Companies who are going to flop don't do this-- especially in such a phased and controlled manner. More importantly, to your point about Options Contracts-- Elon Musk has a target of $50B to be able to exercise them. This number is significant in my mind and to increase my conviction he mentioned that his money would be the last out-- FILO. I got the same feeling when I was looking at Apple back in 2007 after all of these elements came together. I'm not going to miss the train. I'd argue when the stock was $30 there were more barriers than now. Barring an catastrophic event, everything is now a game of execution. I think after more milestones and goals are met investors need to take notice and will realize that Tesla will get to the goal of $50B in a few years (I'm thinking 2016).

Here are some old barriers for reference:
1. Tesla will never make a viable electric sports car-- made one.
2. Tesla will never sell this many electric sports cars-- sold them.
3. Tesla will never make a electric sedan with no compromise-- made them
4. Tesla can't make these sedans on time-- Delivered a month early
5. Tesla will not have enough demand for these sedans-- There's a huge waiting list

Anonymous said...

Telsa sales are heavily subsidized by tax dollars.

http://www.forbes.com/sites/patrickmichaels/2013/05/27/if-tesla-would-stop-selling-cars-wed-all-save-some-money/

valur_fannar said...

One quick thing on taxes in your model.
You assume 0% tax for the first years and gradually increasing tax % until year 10 when they hit full tax.

The difference between this and using full 35% tax all the years, should be the tax shelter they're expected to use, right ?

The difference between these two scenarios is ~3bn. or a lot more than the 1 bn. they have rolled forward... or am I missing something ?

Bo Yang said...

Hi Professor Damodaran,

I'm playing with your Excel file and I have this question. On the "valuation output" sheet, if I fill in cells M13:14 (copy L13:14 and paste to M13), the PV(FCFF) is $1,348.98 for the terminal year, or about $11.1 per share.

The value in the FCFF cell is operating income minus tax minus reinvestment, isn't that pretty close to earnings ?

If so, we can take the trailing P/E of 15.84 for the automotive industry from the "Industry Averages(US)" sheet, and calculate the stock price to be $175.8/share, pretty close to the current price.

What am I missing here ?

Anonymous said...

Excellent analysis. One point to emphasize is most of their future growth is based on the low end 35k vehicle. There has been no development updates on that model and bmw is coming out with theirs next spring. Since bmw is first to market, every sale of an i3 is a lost sale for tesla's future low end car. Bmw is brilliant in that they are not competing with tesla directly but going after the lower end with the i3 and the upper end sports car market with the i8. If tesla doesn't step up development, they will quickly shrink into a niche market with limited growth.

Anonymous said...

Lets make this simple (Occam's Razor)...
The market is always right.

Trying to explain why the free market is wrong in its pricing of such a stock is very wrong to teach your students unless you really want them to fail (which is a possible conspiracy theory).

Instead, the professor should write about reasons why the current market price is correct...and perhaps could mention what he thinks are risks to causing the masses to lower the stock price (poor execution, a competitor creating a better product, something bad happening to Elon, etc.).

Simple is always best, trying to fit a model on an innovative growth stock is completely erroneous and irresponsible.

Anonymous said...

Tesla is a very young company, yet to prove its competitive advantages.

I wouldn't place it yet between Peugeot and Audi who have been around for ages.

My estimates: Sales to capital ratio starts from current 0.78 and linearly increases each year to reach 1.5 at year 10 and stays there. Revenue increases first 5 years at 50% and then linearly decreases to reach 2.75% growth rate at year 10 onwards. Revenue reaches $26 billion at year 10 which is between Tata Motors and Suzuki in the table. Target pre-tax operating margin is 10% which is actually at the higher end when compared to the bigger auto companies.

Final value comes to a negative number, meaning less than its current liquidation value. I can change sales to capital in conjunction with growth rate to bring it to a positive value, but I won't.

Conclusion: Tesla should perform significantly better than my estimates, or close shop and return capital back to its shareholders.

Auto is a capital-intensive, highly competitive business where excess returns are rare.

NSA said...

Great analysis. I think you're spot on.

I would love to see a similar analysis done on Amazon, or Apple, backdated by 10 years though. I doubt you'd get to their peak valuations.

All three are disruptive business models led by mercurial characters. Very hard to bet against.

Navin said...

Professor,

"will have to invest about a dollar in capital (in either R&D or plant/equipment) for every additional $1.41 in revenues"

That sounds like a dampener. How much dollar has to be invested to make a 1$ of profit ? (sounds more like 10$ ?)

Anonymous said...

Dear Professor,
Can you please clarify the R&D expenses. My calculation indicates 273.978-143.245+107.171=237.904
but it seems to be taken as 310.06 which is opposite (i.e 273+107-143)
Is this a calculation mistake or I am wrong here??

Anonymous said...

Dear Prof. Damodaran,

Going with your assumption of pre-tax income of ~$8 Billion in 2022:

If I ballpark the earnings at $5 Billion at that point and use a P/E of 10x-20x, would the stock not value the company at $50-100 Billion come 2022? This equates to a stock price of between $384 and $768. How does that reconcile with your present day valuation? If discounted at your 10% cost of capital, that means a PV of $150-$300 today.

Aswath Damodaran said...

With a young, growth company, you cannot divide your value for equity in ten years by the number of shares today. To get the growth that you have forecast in the model, you have to raise fresh capital (primarily equity) which will effectively increase the number of shares over time. That effect is built into the DCF model as negative free cash flows. If you use a multiple, as you are, you have to then adjust the number of shares by the expected dilution that will occur over time.

Anonymous said...

Very interesting article and comments that were mostly worth reading. In my opinion, the massive short squeeze was a major factor in Tesla's huge run up. Do you feel this will continue to be a factor?

I had noted the 25 million options looming (about 1/5th of current shares extant )but yours is the first mention of it I have seen. It seems possible more might be issued, leading to further dilution, right? That would alter the numbers, it seems.

A lot of Tesla's playbook recalls Amazon's, another company lead by a clever man who has obviously studied how to advance his stock price, while seldom, actually making much in net profits, by skillful manipulation archetypes and narratives that lead to rampant Kool Aid consumption.

Craig JoYce

Anonymous said...

@Anon "There has been no development updates on that model and bmw is coming out with theirs next spring. Since bmw is first to market, every sale of an i3 is a lost sale for tesla's future low end car."

To be fair, Tesla promises 200 miles of range (pure EV range) for their Gen 3 car due in 2017.

On the other hand, BMW might update their i3 within 4-5 years to match Tesla's range with better batteries.

A lot depends on battery pricing and battery R&D within 5 years.

In 2013, Tesla's 200 miles is just a promises.

Glenn Mercer said...

One thing to perhaps think about is that a "mature" car company (I am referring to one that has been in business many years, not to the maturity of the technology employed) makes half and in some cases more than half of its profits on spare parts, both regular repair and maintenance parts, and collision repair parts. For PSA, it may be ALL their profit in recent years. Both Goldman Sachs and Bernstein have done good research on this topic: anyone interested can send me an email at gmercer2 @ gmail.com and I can forward reports. I mention this because I wonder if it is something that one would tend to take into account in projecting future profitability for Tesla. The average person is generally convinced that car companies make their money selling new cars, but by the time one takes out option profits (there was a wonderful analysis done showing that the profit on custom paint colors can equal profit on the underlying car), after-sales parts, and financing, it gets more complex. (Yes, yes, I understand that one cannot sell options or financing unless one sells a new car. It is just fascinating to me how the profit drivers are not always the obvious ones.) Glenn Mercer

Steve Sheiner said...

Tesla is the Apple of the auto industry. They're innovating in a way that the large companies can't and paving the way for innovations that will have a real impact on how all auto companies operate.
Whether they'll be around as a stand alone company to reap the rewards is questionable. Going from 5k cars a month to 100K is no mean feat.

Anonymous said...

Where is the innovation?

1. Battery instead of gas? And the battery's made by the Japanese?

“One of the bigger challenges for us is going to be lithium-ion cell production,” Mr. Musk said at Teslive. “We need a lot of batteries.”

He said the company was working with Panasonic, its main cell provider, to increase manufacturing capacity.

Tesla grew 20 times in one year because it's cool to drive Tesla.

There isn't a lot of innovation. It's marketing.

Apprentice of Agamas said...

Dear Prof.

In your Spreadsheet for Tesla's valuation, unless I'm missing something (quite possible), did you get the values for Cash and cross holdings backwards ?
ie: "Last Year" should be 201.89 and "This year" should be 746.06

neroden@gmail said...

"That matches the industry average of the sales to capital ratio of 1.41 for US companies. Since the sales to capital ratio for technology companies is higher (2.66),"

Electric cars require less capital investment than gasoline cars. This shows, once again, that one has to know the actual technical details of the industry in order to value a company in it.

For a comparable business in terms of *capital investment*, you would want to look at other businesses which make electrical equipment. Neither "tech" nor "auto" is the right comparison point.

neroden@gmail said...

"For example, owners had issues with Alcantara headliner (due to allergies). This is a high margin item which Tesla now charges for."

*waves* That's me. Actually, it's unfair to say "owners" -- I think it was just me who had the allergy!

neroden@gmail said...

"(B) time value of money (not to mention the nature of long-run economic profit) makes your view of the car market in 20+ years effectively meaningless, which seems to be the overarching concept here"

What long-run economic growth? What time value of money?

The Great Recession, and the zero-interest-rate environment, and the very low inflation rate, actually changes value computations a lot by changing the point of comparison.

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Anonymous said...

I have never shorted a stock before, but I am massively short TSLA. Stock is crazy. When we start valuing companies with, "but it's a new technology, at 15x sales you are using the wrong valuation technique...," you have lost all of your margin of safety. I agree the future is unknown, but to value it so richly seems like a losers bet.

Anonymous said...

One thing fanboys of TSLA are missing is that it does not improve convenience. The Comparisons to other disruptive products like AAPL,NFLX is a little bit stretched. One thing common to those those @ the time they came out is that they made things more convenient& simpler to use, this is something TSLA lacks. The idea of having to plug the car in to recharge , planning your driving, are inconveniences compared to what is the norm now.
I absolutely love the car but the valuation is just wrong and too high. What would help is when we have roads that can charger batteries inductively but unfortunately by that time (if ever) the competetion would have caught up with TSLA and it will no longer be a niche product. Absolutely agree with the author

Anonymous said...

Hello Professor,

Thank you very much for providing your wealth of knowledge and resources. I am interested in developing an industry analysis for the small cap basic materials market, and wanted to know where you pull your data such as the one you used in your analysis of the automotive industry.

Sanola Jerry said...

Accounting for all the details for the financial transaction of the firm can help to better analyze the situation so that a good step has to be taken.

Thanks
Sanola Jerry

Accounting Software

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CCC said...

May I know why the operating leases are not capitalised in this model?

please refer to pg 124 of Tesla's 10K report.

Please advise.

Thanks!

Sanola Jerry said...

In some cases the spreadsheet is password protected and can't be opened without passwords.Is it possible to cracjk this password by hit and trail method.

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Michael Zhang said...

The model simply suggests to us that theory sometimes does not apply to reality, especially in stock market. Financial models can only be built on assumptions. For a company like Tesla, there's no correct assumptions, not even a closed one. Comparing the EV maker with traditional auto makers will be proved totally wrong. With the help of advanced technologies, Tesla is able to produce cars with far less labor costs than traditional car makers. It does not have the legacies, or in another word, burdens which others have.

The model can not capitalize the critical success factor in this company, the entrepreneurship. You can't imagine what other great innovative ideas Mr Musk would have to make the company more successful.

Even if it possible to value the stock by DCF method, the assumptions of capes and profit margin were based on traditional car manufacturers which I'm quite sure not applicable to Tesla. And that maybe the reason that why so many investment bankers set the target price of this magic stock to $200 and maybe above.

Anonymous said...

One issue on Tesla which does not appear to have been addressed thus far here or pretty much anywhere else is this : 30% of customers sign up for the buyback scheme whereby Tesla guarantees to buy the car back at a fixed price at a certain date in the future. This is, I think, therefore, a future liability and it only goes up as they sell more cars. How do we account for this? Clearly there is a huge balance sheet/inventory risk here since whilst TSLA is guaranteeing a buyback at a fixed price, we cannot know what price the second-hand/used market will assign to Tesla's going forward. Also they will necessarily be permanently be sitting on inventory, perhaps in the thousands or even tens of thousands. One thing we do know about cars is that over time they depreciate. Would welcome any thoughts from the Professor on this overlooked issue.

Anonymous said...

Has anyone noticed how may staff Ford and GM and so on have? It seems to be in the hundreds of thousands. Tesla has barely 3200. How will Tesla become a big car company without also having to hire tens of thousands of people?

Anonymous said...

Is circular reference in valuation s/s intentional (sheet "Option Value": C15/C26)?

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Bruce Kehn said...


RE: http://wp.me/p2BJXK-b2


One of the people where I work has a Tesla, we saw the articles about multiple Tesla fires at http://wp.me/p2BJXK-b2

I have now read that many Tesla owners have complained of fire incidents in their blogs. Please clarify to me how there are multiple documented fire incidents yet you say there has only been one? Do Tesla batteries blow up after they get wet? DOn't park your Tesla anywhere near your home or you may find your house burned down.

Anonymous said...

Unknown.... When Bulls became bullies it's best to walk away. Joel seems more focused making negative assumptions about the prof then better understanding possible outcomes.

Jack Smith said...

Thanks for sharing this post about car valuation. Here you mention the truth ,that is BMW and Daimler make the top ten in the list, but they are selling far more than just luxury cars. People always check current market price with online tools. People should evaluate used car with help of best technicians or through used car valuation tools. If you need a reference point for determining the price then compare with someone from who own a same auto. Here i have given some suggestions for Cars valuation

Anonymous said...

The problem with the MSFT, Apple comparisons is that there is adverse selection in choosing this names. For every Apple/MSFT/Google that succeeded there was many a hype stock (or companies that didn't even get to list) that fizzled and died along the way. Its a human bias to look at outcomes and not think about companies that showed the same potential but are not visible today (because they went under). It's one of the points constantly made by Taleb in his books.

fidodido said...
This comment has been removed by the author.
Shai Harony said...

Tesla Is Worth $67.12

Deanna said...

Oh Oh: "More Tesla cars on fire, exploding. Tesla Stock tanks:


http://abrege.eu/truth


http://lithium-ion.weebly.com"

fidodido said...

I see that your models use a fixed ratio, say 1.5 for auto companies. Isnt it that some companies will be less efficient in converting capital to sales and some will be more ? How do we factor that , when taking this fixed sales to capital raio?

Skypilot said...

I can't comment on the probability that your analysis is accurate or not. What is apparent is that the stock price is not driven by any fundamentals at this time.

Additional risks may become apparent with time.

Lithium Ion batteries have a fail mode that results in self combustion as evidenced by the UPS cargo jet crash in Dubai and the 787 grounding due to battery fires, so we may not have heard the end of this subject yet.

As far as EV's becoming a mass market solution, I believe there are two challenges that will limit that solution. One is summer commute times in the major metropolitain markets. Summer temperatures in bumper to bumper traffic with long commute times may become problematic as cooling needs consume more usable range, driving the need for more daytime charging kWH, which at some point is going to affect electrical load peaking and the need for more power plants.

Fuel cell vehicle introducion combined with CNG may offer a better mass market solution. This is something on which hopefully TESLA can capitolize early.

A quick glance at a three year chart shows TESLA to clearly be a speculative stock. Fun to own, appropriate for a small, high risk tranche of a portfolio.

Anonymous said...

a investment that need fairly optimistic assumption lacks a good margin of safety.

QCEP Consulting said...

What they do among others is giving financial advice. They must have advised some of their customers to buy as much cheap Tesla as they can before it goes up and stays up permanently.

Business valuation also helps you raise equity capital

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PENNY STOCK INVESTMENTS said...

This stock has way to much hype.

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Michael Zhang said...

I looked back at this thread and happy to find that the stock price went the way I expected. Once again I would like to emphasize financial models are not reliable enough to valuate this kind of stock as entrepreneurship can't be correctly valued.

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This comment has been removed by the author.
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