Tuesday, March 25, 2014

Return to the firing line: Revisiting Tesla and hopefully living to tell the tale!



In September 2013, I valued Tesla on my blog at about $67 and learned a lesson about how passionate its stockholders were in defending it, viewing it less as an investment and more as a calling. I guess the lesson did not stick, because I am back for more punishment with an updated valuation of the company. Preempting some of the criticism that I may get for my post (and the views that it contains), I would like to put some basic facts on the table before I put down my valuation.
  • No, I don’t hate Tesla and Elon Musk. In fact, I think Tesla is one of the most innovative companies that I have seen emerge in a while and not only is it changing the automobile business, but it is doing so with style. As for Elon Musk, I wish that the CEOs of other companies were as passionate and visionary in promoting their companies' mission and products, as Musk is with Tesla.
  • No. I still have not driven a Tesla. I do live in New Jersey, a state that is attempting to use twentieth century regulations to stop a twenty-first century company. I also live five minutes away from Short Hills Mall, where Tesla just opened a showroom. So, I have seen the car, sat in it, but unless I want to create a disaster inside a mall, I don't think I can drive it out of the showroom.
  • No, I have not sold or plan to sell Tesla short. I also do not work for anyone who has sold short on Tesla, have not been paid (and will not be paid) for this post and won't be cheering if the stock retreats. In the interests of fairness, I do know one person who has sold short the company's shares with some success, but have not partaken in his profits.
  • No, I don’t believe that my valuation of Tesla is the "right" valuation of the company. It is mine, with my assumptions, estimates and views embedded in it, wrong or misguided though they might be. 
  • No, I don't think you are crazy, if you own or recently bought Tesla. I am a firm believer that each of us has to make our own judgments on what to invest in and why, though we all share the same end-objective, which is to make money on our investments. So, if you have good reasons to believe that Tesla is the right investment for you, I hope it works out for you.
Having dispensed with the formalities, let me move to substance. 

Valuation: Then and Now
In my September 2013 valuation of Tesla, I came up with a value per share of $67. At the time, the narrative I provided for the company was that giving it the revenues of Audi (about $65 billion) and the margins of Porsche (about 12.5%), in a decade, still yielded a value below the market price (about $170 in September 2013). Rather than rehash the assumptions I made in this post, you can find them in my original post

Since that valuation, there have been earnings reports that have contained substantial information about the growth trajectory and profitability of Tesla, as well as other news stories about the company, some positive (Consumer Report awards for its cars, the $5 billion investment in the world's largest electric battery factory) and some negative (Tesla car fires). All of these news stories provided information that led me to reassess some of the key inputs that I used in my valuation. 
  1. Revenue growth: Tesla continues on its path to higher revenues, reporting revenues of $615 million in the fourth quarter of 2013, doubling its revenues from the same quarter a year ago. The annual revenues in 2013 amounted to just over $2 billion, an almost five-fold increase over the $413 million in revenues in 2012. 
  2. Operating margin: In further good news, the operating losses (based upon GAAP) at the firm decreased over the period, down to -$13.4 million in the last quarter of 2013. In fact, adjusting for R&D expenses (capitalizing and amortizing), I estimate an operating profit of $15.46 million in the last quarter of 2013, vindicating the company’s claim that it turned the corner on profitability for the year (albeit with a very different rationalization). 
  3. Quality of Growth/Reinvestment: The measure that I used to estimate reinvestment and the quality of growth was the ratio of sales to invested capital. On this measure, as well, Tesla reported improvement in the last quarter of 2013 as the ratio improved from 0.66 in the third quarter to 0.87 in the fourth quarter; a dollar of invested capital generated $0.87 in revenue in the last quarter. (Higher values not this statistic indicate bigger payoffs to investment.)
  4. Risk: There are mixed signals in whether Tesla is getting less risky over time. The volatility in the stock price has actually increased over the last few months, as the stock first dropped on the news about car fires and then recovered quickly and decisively. However, the announcement that the company would raise $2 billion in convertible bonds is an indication that it is opening access in other markets and that will stand it in good stead, if it needs more capital to either grow or survive. 
The table below lists the key assumptions in my September 2013 valuation, the changes in the March 2014 valuation and my explanation for the changes.




September 2013 
March 2014
Rationale
Spreadsheet
See the gory details.
Base Revenues
$1,329 m
$2,014 m
Base Operating Income
-$22 m
-$17 m
Expected Revenue in year 10
$65,422 m
$79,215 m
Added revenues from the electric battery business to auto revenues.
Expected Operating Margin in year 10

12.50%
12.00%
Battery margins are likely to be lower (competitive business), pushing down the target margin.
Expected Operating Income in year 10
$8,178 m
$9,505 m
Comes through from higher revenues.
Sales/Invested Capital ratio (to compute reinvestment)
1.41
1.55
Reflects improvement in last quarter of 2014.
Cost of capital
10.03%
8.86%
Decline in market ERP from 5.8% in 9/13 to 5% in 3/14. Increase in auto sales led to make it slightly more automobile (60% to 70%) and slightly less technology (40% to 30%).
Probability of failure (Proceeds from failure)
10% (50% of estimated value)
0%
Increased access to capital (bond market), lower losses and larger market capitalization should allow company to survive even major shocks.
Value of equity
$8,152 m
$16,681 m
Increase of 105% in nine months.
Value per share
$67.12
$99.85/ $118.47
The value per share is lower ($100), if options get exercised at current price or close to it, and higher ($118), if option-holders wait and value converges on price.

Note that while the increase in year 10 revenues of $13.8 billion, largely the effect of increased revenue potential from the electric battery market, is substantial, it falls short of what you would expect to see if this were a ‘disruption” of the electric utility market. The improvement in margins in 2013 is encouraging, but they are in line with the expectations built into the September 2013 valuation, and entering the electric battery market is likely to lead to lower margins, not increase them. (The pre-tax operating margin for global electronics companies is 5.67% and that of power companies globally is 11.62%; neither is a perfect fit but you can download the industry average margins by clicking here). The decline in the cost of capital is more the consequence of change in the overall market environment, where the rise in overall stock prices in the last few months, has lowered the equity risk premium. Tesla’s foray into the bond market, with its $2 billion convertible bond issue, suggests that the company has opened up access to more capital, if it needs it, and shows up in the setting up of the probability of failure at 0%. 

Overall, the effects of these changes is to increase the value of equity by about 105%. The effect on the value per share is smaller, largely because the company has 22.64 million options outstanding in addition to its 123.19 million shares outstanding. If we value these options, using the current stock price as the basis, we obtain a value per share of $100, but using the estimated value per share (I know.. I know.. there is circularity and that is why the excel spreadsheet is set to iterate) yields a value per share of $ 118. The danger with using the latter approach is that the option holders, assuming that they see what we see in this valuation, will be inclined to exercise when the price is high. Splitting the difference, the value per share estimate that I would attach to Tesla is between $110 and $115 per share. 

Can the intrinsic value per share of a company close to double within a nine- month period? Yes, and with young growth companies, you should expect your estimates of value to be volatile over time, as you learn more (good and bad) about the company and its business. Does it bother me that value is so volatile? No, because it is not how volatile the value is, but how volatile it is, relative to price, that drives investment decisions. This is after all a company whose stock price has quadrupled, halved and doubled again all in the period of two years. 


Price and Value
Tesla is a perfect case study for the dilemma that I posed for “value” investors in my post on buzz words, where you reject a stock as over valued, only to see the stock price increase even further. In September 2013, I valued Tesla at $67, when the stock price was $170, and concluded that it was over valued. Nine months later, the stock has gone up to $220, and even with my more optimistic outlook on the company, I have a value of $115-120, well below the market price. The trader ranks beckon, but as an investor, I have three choices with Tesla:

1. Delusion: Do a quasi DCF!
There is widely held presumption that if you have a set of cash flows on a spreadsheet, and you estimate a discount rate, you have done a DCF, which is the equivalent of  claiming that wearing tights and ballet shoes makes you a ballerina. There are simple tests you can run to differentiate between good, bad and indifferent DCFs (and I will have a post dedicated to that topic), but in the context of Tesla, there are tweaks I can make to the model that can very quickly alter my value. For instance, if I set the sales to capital ratio at 10.0 (i.e,, that I can generate $10 of revenues for every dollar invested), the value per share goes to $302/share. Magical, right? The only problem is that I would then be assuming that Tesla will generate about $68 billion in incremental revenues and $9 billion in incremental profits, over the next decade, without building any factories or making acquisitions. Unless Tesla has discovered a way to build cars and batteries on virtual assembly lines, manned by Oompa Loompas, I don't see a way to justify this. In fact, Tesla's announcement that it would be investing $5 billion in its new electric battery factory suggests that the company knows that it has to make substantial infrastructure investments over the next decade, to deliver its growth potential.

2. Disruption and China: Attaching value to buzzwords
The last earnings report from Tesla was followed by the announcements that the company would start selling its cars in China and that it would be building a gigafactory to produce electric batteries. If you were working on a checklist for buzzwords, you would have hit the trifecta with this announcement: a company with growth potential announcing that it would enter China and disrupt an existing business. These announcements have valuation implications, but they have to be made explicit, if they are to the taken seriously.

Take, for instance, the argument that the electric battery investment represents the entrée into the market for supplying electric power for other uses (homes, businesses etc.). If the argument holds, it could be a value-changer, since the electric utility market is an immense one, in terms of revenues, albeit with much lower returns on capital. For disruption to justify today's stock price, the change in revenues will have to be far larger than the estimates in my valuation. If you believe that Tesla has the capacity to disrupt the electric utility business, the table below should give you a sense of the break-even points (to justify a $220 stock price):

There are a couple of interesting details in this table. The first is that while there is tremendous upside potential, the break even points to get to a $220 value are daunting. If the pre-tax operating margin converges on 12% (as assumed in my base case), you would need total revenues of more than $150 billion to justify the current market price. In other words, your battery business will have to add about $90 billion to Tesla's annual revenues by the tenth year. If margins drop, the current market value is not only unreachable, but growth can become a value destroyer. For instance, with a 4% operating margin, given the reinvestment needs in these businesses, increasing growth makes your value become more negative. If you buy into the disruption model, the challenge then becomes determining how much that disruption will create in additional revenues (in the electric utility business) without damaging profit margins. It is worth noting that Tesla is not the only player in this disruption game, with Honda having already jumped into the fray (albeit with their smaller and less powerful electric batteries) and Hyundai and Toyota getting ready to enter. 

There is also the possibility that there are companies that would be interested in either acquiring Tesla (a tough task, since Elon Musk has been insistent that he will not sell) or partnering with it to create value on joint products. Given Tesla's burgeoning market capitalization, the list of potential acquirers/ JV partners does get smaller, but it is possible that the promise of a Google/Tesla driverless car could tempt Google to invest some of its substantial cash balance in Tesla. 

3. Keep the faith
My investment philosophy is built on the foundation that you should buy an asset only if trades at a price less than your estimated value for that asset, error-prone and uncertain though the latter may be. It is true that I can offer no proof that my value is right, that the price is wrong or even if the first two assertions are true (right value, wrong price), that the price will adjust to the value, but is that not the essence of faith? That you believe, without proof! If I stay true to my philosophy, I cannot justify buying Tesla at the current price. Of course, a year from now, the stock may be at $400, but I will have no regrets, because I also believe that if you don't stand for something, you will fall for anything. 

Your philosophy on investing may be different from mine, and probably better (or at least more lucrative). If you are a Tesla stockholder, though, I hope that you are one for the right reasons. That would include being a trader (whose focus is price, not value), buying into the disruption model or investing on the expectation of an acquisition, but it would not include investing because others have been making money on the stock, equity research analysts are bullish or just because you love the company, its products or its CEO.

Thoughts on markets
It is easy to become cynical about markets and to cast those who have different views than you do into the "irrational" or "crazy" camp. Even if the Tesla run-up turns out to be overdone, look at the bigger picture, which is that a company that was non-existent five years ago has shaken up a sector where there have been no new entrants for decades. I have nothing but admiration for what Elon Musk has built over these few years and I hope he succeeds. In fact, I will keep valuing Tesla, every few months, and there will be a time, sooner rather than later, where I know it will be part of my portfolio. Just not yet!

Note: If you don't like my assumptions or inputs, use the valuation spreadsheet below, change my assumptions to yours and make it your valuation. If you are so inclined, share your views in the Google shared spreadsheet that I created for this valuation.

Additional links

84 comments:

Vijay KK said...

Thanks, great post! But are we 'over-thinking this? Could the reason simply be down to the behavioural-herding element symptomatic to market excesses and bubbles? We see it everywhere - junk bonds to Social Media.

Would like to invite you to some of the excesses we have over here in India. 'Just Dial' for instance?

Regards
Vijay

Anonymous said...

Have you done any posts on capital intensity (or would you)? The sales to capital ratio here seems to be a key driver of the valuation, and my understanding of this feels lacking.

Anonymous said...

Professor, are you sure you've got the revenues right? Google Finance is reporting $614.22m, against your $667m.

M

Aswath Damodaran said...

All of the points you make about herding and bubble and market excesses are stories about price. They have nothing to do with value. It is possible that the difference between the price and value is due to these reasons, but assuming that these are always the reasons without exploring possible explanations strikes me as imprudent.

I will check the revenues out for the fourth quarter. It really does not affect my valuation, since my base number is based on the annual revenue for 2013 which came from the 10K.

Anonymous said...

Even though most times it takes a few years, Value investors love it when the Momentum fellas come on board for a ride.

Condolences to you for missing out on this fact.

Aswath Damodaran said...

Anonymous,
When did value investors get on the Tesla boat (on the ride up) or are you taking about the prospective ride that you hope to have on the ride down? Value investors, at least as defined in the classic sense of the word, have not been players in Tesla and will not be for a long time and it has nothing to do with it being under or over valued. It is because classic value investing is so enamored with cash today and mature businesses than no growth company will make their cuts.

Anonymous said...

Hey professor, do you think its a good time to buy $IEP

Steven H said...

Aswath, I have posted a comprehensive rebuttal on Seeking Alpha,

first question, why do you begin your piece by attempting to frame those who see a higher valuation for Tesla than yourself as a "calling", suggesting some sort of religious dismissal of reality? Can we have this as a discussion of open comparison of assumptions and modeling rather than pre-emptive ad hominem attacks?

as to your analysis, somewhat improved, but still fundamentally distorted as your analysis from the fall.

On a most basic level,

you write of operating income of $9.505 billion in 2024. assuming a 25% effective tax rate (far more than the average corporate tax rate actually paid), Tesla would earn $7.1 billion. as you have indicated current shares outstanding and options imply roughly 146 million shares to divide this income over. Let's round that up to 170 million shares in 2024, that is let's ADD 24 million shares to cover potential future dilution to raise capital, and allow for more employee options.

the $7.1 billion in earnings divided by the inflated 170 million shares comes to $41.75/share in earnings in 2024.

to adjust for risk factors, let's say your scenario has an 80% of being executed, and there is a 20% chance Tesla only achieves half that eps in in 2024. the weighted average of these earnings is, $37.58.

what pe do we assign to Tesla in 2024? This largely depends on whether you see EVs as a niche or the ultimate destination of global vehicle production. This would be a large topic for conversation. Despite the nearly two years I've been researching this convincing me of EVs ultimate clear superiority to ICE, I will entertain the notion of a niche product with equal weight. Thus, a niche growth player with cutting edge technology might have a pe from 10 to 20 depending on overall market bullishness, whilst, a the leading company in a transformation in of the over 100 million/year vehicle market (circa 2024) that is only roughly 3% complete at the time might have a pe from 30-60. Averaging the pessimistic scenario as equally likely as the optimistic (which again I think is extremely unlikely), we arrive at a pe of 30.

thus, Tesla, circa 2024 would have a price of $1,127 based on the revenue and margins you are assuming.

Steven H said...

continued rebuttal,

discounting back to 2024? I've accounted for Tesla's capital requirements in the 24 million share dilution count buffer and Tesla's reinvestment of earnings (and as you'll see below, I'll assume they have to invest another $5 billion to $15 billion in basic capex in some adjustments I make in a lower valuation). thus the only discounting I see worthy is considering what my money might earn if I invested in an index fund rather than Tesla, and I use a 10% alternative investment rate to determine that Tesla is an interesting investment to me at $435 when I use your assumptions.

(you might say 10% returns in an index fund are a surer bet than Tesla. 1) I'd disagree, given market turmoil, and a rolling of bubbles through the economy still not addressed, I'm more confident in Tesla's executing that return than than an index, 2) even if we assume Tesla has to hit 15% returns to be worth the risk, the current Tesla valuation based on your assumptions comes to $278).

Now, I actually, in my own modeling, value the shares at roughly $300, not $435 your numbers suggest. This may largely reside in my subtracting $500 million to $1.5 billion from earnings for the annual depreciation of plant and equipment Tesla will need to ramp up production... that is a buffer to the margin assumptions beyond what Tesla offers (this is based on 10-year depreciation halved if they do 20-year depreciation).

It would be helpful if you specifically shared your assumptions for 1) vehicle types (i.e., Model S, X, Gen III, other TBD) and 2) your average sales price for each vehicle type. One can only decide what capex expenditures are reasonable if one knows the vehicle volumes assumed.

it's worth noting, that even with the astounding implied $435 price target based on your assumptions, you are assuming 12% operating income while Tesla has repeatedly said long term earnings (after taxes) will come in at low to mid-teens of revenue. yes, you knocked down 0.5% for lower battery margins, but his hardly accounts for the discrepancy. it's also worth noting that your assumptions, as far as you've specified disclose nothing for the battery storage business.

One last note. I saw where this shortfall of your valuation of Tesla was pointed out to you in the fall and you wrote your third blog. I read that third blog, it was a jargon filled, double counting filled, attempt to justify a valuation that suggested a Tesla fair value in the $200s really was a $66 valuation. In any response, please stick to clear direct statements, and please avoid jargon and double counting. if you have a logical reason a company your assumptions suggest will earn $37+ in a decade should only be valued at $120, please provide it in direct and clear explanation. Surely we are all interested in reasoned and open discussion, not blind acceptance of the "say-so" of "experts."

Aswath Damodaran said...

Steven,
You did not have to post a rebuttal on Seeking Alpha since you have done it here. Since you have made the central estimation question what the PE for Tesla will be, using 2024 estimated earnings, let me respond. First, you cannot divide 2024 earnings by the number of shares today, with or without the options exercised. With my assumptions, Tesla will need billions of dollars of reinvestment over the next decade and much of it will have to come from equity (Even their convertible bond issue is bond only in name; it is most equity options). Thus, when you look at the share count in 2024, it will be much higher than today.
You can take issue with my reinvestment assumptions and that is perfectly fine, but if you are right and all of these incremental revenues and earnings can be generated with $10-$15 billion in additional investment, there is no disagreement. Tesla is a great buy. However, that would give them a return on capital of 30-40% in 2024, and I am hard pressed to think of a manufacturing company (with infrastructure investments) that earns those returns as a mature growth company.
You are right. I should have attached a qualifier on the word "calling". It was not intended for someone like you who clearly has a financial rationale. It was more a response to the many emails I got in September that rebutted my valuation with a question: "Have you driven a Tesla? And if you have, how can you ever find Tesla to be over valued?"

Steven H said...

Aswath, thanks for your reply (and excluding me from the "calling" camp).

having read your latest blog more carefully I see that you are looking to buy Tesla sooner than later. If you read my comments more closely, I think you'll see sooner may be sooner than you think.

Firstly, as to increasing share counts. A closer reading of my rebuttal will show you that I have assumed Tesla will need to add 24 million shares, on top of current shares AND current options outstanding. I expect about half of that will go to finance their capital expenditures (probably fetching $3-5 billion), the rest will go to additional employee compensation.

Here are some basic facts on Tesla's capex needs and capital raising ability you seem to be missing,

1) your latest blog described Tesla needing to spend $5 billion on the battery factory. While Tesla said the cost of the factory will be roughly $5 billion, their intention is to pay $2 billion, with the rest of the funding from partners. yes, plans do not always work, but this is the base case.

2) Tesla already owns the Fremont plant. Tooling to bring the plants capacity up to 500,000 vehicles per year is expected to be about $1 billion.

thus, $3 billion to reach 500K/year volumes in 2020. they look on track to earn that much money just from Model S and X sales from 2015-2018. they've already raised that money from two convertible bond offerings this past year, adding about 10 million shares of possible dilution. thus the money is in hand, and the earnings to pay it back if the convertible is not turned into stock are achievable with a buffer (2014, and 2019-2020 earnings).

the estimates I use to get to a $300 valuation assume a second manufacturing plant, and a second giga factory, totaling roughly $5-10 billion depending on whether giga factory 2 is done solo or with partners.

that $5-10 billion will come largely from earnings, but I've left room for dilution in the 24 million shares I've added to my estimate. this dilution may not be necessary... a 2020 Tesla with a successful Gen III product will not be confined to issuing shares to raise funds for expansion.

your slicing Tesla's value to a third of what your numbers otherwise suggest based on dilution to raise capital is simply not tenable.

I think you would do well beginning a position under $210. I wouldn't be surprised if we see a price as low as $170 with general market volatility.

Anonymous said...

Professor,

Minor nitpick on your March valuation on Tesla spreadhseet. On the input sheet, cell B25 (Sales to capital ratio), you said to use B3/(B5+B6). I assume you actually mean B8/(B11+B12) [sales over the sum of book equity and debt).

M

Aswath Damodaran said...

Steven,
I an glad you responded because you have crystallized the key reason for the different values that we get. You are assuming far less in reinvestment than I am, and that is the reason you are issuing only 24 million shares. My collective reinvestment over the next decade is $50 billion, resulting in capital needs of $32 billion, translating into 160 million shares.

I like your explanation for why Tesla might be able to get away with lower reinvestment needs, i.e,, that they have excess capacity in their Fremont plant and can use it to produce more cars. I am not sold on the idea (yet) but that is what I am watching more any other statistic at Tesla. The last quarter of 2013 was a very good quarter, since almost of the revenue jump came from investments made in prior quarters.

Thank you also for the price trigger of $210. I am stubborn when it comes to value and it may be take me two or three more quarters of stellar numbers to get there, but my mind is not closed.

Aswath Damodaran said...

Anonymous,
You are right about the cell references in the input page. Have fixed them (and netted out the cash in the process).

Steven H said...

thanks for the response Aswath.

Clearly you have a full time job and Tesla is one of many "market musings" you can only devote spare time to. In contrast, I have spent a tremendous amount of hours studying Tesla for just shy of two years. Time to dig deep into Tesla is plentiful for me as I greatly enjoy it and I am financially independent at 45 from investments in Celgene in 1999 and Tesla in 2012. I only write this to say, Aswath, there's not any harm in acknowledging someone who has spent probably 100X the hours on Tesla as yourself has brought to light fundamental drivers clearly indicating the need for a revision to your valuation!

In your latest comment you've just written that your valuation is based on Tesla issuing an additional 160 million shares, that is going from ~140 million (current count + current option exposure) to ~300 million, to cover $50 billion in capex in over the next ten years.

The question is $50 billion for what exactly?

1. $1 billion to reach 500K vehicle production capacity.

The Fremont plant capacity for 500K can quickly be confirmed via a google search.

The $1 billion for tooling to produce Gen III has repeatedly been described by Tesla and the analysts as a group. you can call either to confirm, round up to $1.5 billion if you like. Ramp up of Model X and Model S production probably adds about $250 million more capex if you want to add that in.

2. $2 billion for Giga Factory 1 to support 1st 500K vehicles (straight from Tesla guidance). Yes there is risk that partners do not materialize for other $3 billion.

3. $3 billion for 500K/year capacity second auto plant (past few months I've looked up last several plants introduced in developed world, mostly North America, and extrapolated).

4.. $2-5 billion for Gigafactory 2 depending on whether they partner or go alone to support second plant's production.

4. $1 billion, ample allowance for large expansion of stores and service centers (roughly 500 of each increase globally... way more than likely needed).

Thus, $8-11 billion to scale up to 1 million in vehicle production per year. 1 million vehicles/year is basically commensurate with the auto revenue you've modeled ($65 billion).

It is fair to say that auto plant #3 and GigaFactory #3 will have to have broken ground by 2024 for Tesla to be considered a growth company at that point, so, perhaps another $3-5 billion of cash needed at that point, covering the majority of that addition.

Let's call it $11 to $16 billion. Some of this money will come from retained earnings... quite possibly all of it. Some might need to come from share dilution. Clearly $32 billion to come from 160 million in share dilution is way out of scale with reality... if I understand your last post, you think $18 billion will be available from retained earnings.

Bottom line, you used some generalized statistics that paint a stunningly different picture than the specific capital requirements at Tesla. how awesome would it be for you to just check into what I've described, and have it turn out that you're critical thinking is ready to buy some TSLA! we'll welcome you to the business :)

TSLA OPT said...

Steven H is spot on above. I have been studying TSLA many more hours than you and probably on par with Steven H. Before you read my post below please read his carefully....

Professor Damodaran,
How is it possible that you have not test driven the product yet after all this time and analysis on the stock???? You could schedule a test drive at the mall (before April 1st) or if you message me I will drive to your house and give you a test drive.
It is pure insanity for you to put so much careful analysis and thought into something when you do not even know what it is yet. You may say it is a "car" but it really is not. You won't know that this is not just a "car" until you test it yourself. It is a superior vehicle to any other "car" you have driven, it is new technology that is being deployed and disrupting old technology. The company is also disrupting old business models of its competitors as well with it's vertical integration.
Once you drive it for 20 minutes or a day you will understand that Tesla Motors will sell as many of these 'vehicles' as they can possibly build for many many years to come. The question on valuation should be:

1)how many cars can they build over the next 5-10 years
-my answer is 3mm cars per year by 2024 (with further growth priced into the stock at that point)

2)How high can there margins be and what is the avg selling price
-my answer is 65k avg selling price in 2024 and 20% margins

3)What other sources of revenue will there be and how to model that?
-my answer is definitely: licensing drive-train, licensing superchargers, ENERGY STORAGE batteries, + other unknown surprises to come.

Aswath Damodaran said...

Steven,
Thank you. I am not disagreeing with either your contention that you know far more about the company than I do but as I said, I have to work through this on my own. While your point about Tesla needing less reinvestment that I estimate to grow may be right, that creates a different issue that will have to be dealt with in the valuation. With the reinvestment you are forecasting, the return on capital to Tesla in 2024 will be 40-50%.

Those are amazing returns but they will also act as magnets for competition, which in turn will push prices and margins down. In other words, assuming little reinvestment and high margins in steady state may be too good to be true. I will experiment with lower margins/ lower reinvestment to see the effect on value.

Steven H said...

Aswath,

thanks for acknowledging what you can see in my points.

as to your concerns of competition, after you read this you'll be entering a buy order for Tesla in the pre-market. amigo, slow down, buy over time, Tesla may drift down to 170s if the market as a whole corrects.

concerns re competition, are you ready?

you need to realize Tesla is disrupting the auto industry in slow motion compared to what we are used to in new technologies.

In 2020 the global auto industry will reach 100 million vehicles. If Tesla executes on Gen III as they have on the Model S, EVs will be plainly more attractive in terms of performance, price (factoring in gas savings), and environmental impact.

So, competition will jump in, yes?

No.

1. even if they want to jump in, they can't. the reason, your friend sizable capital costs. remember, if it costs roughly $10 billion to build battery capacity for 1 million vehicles, 1% of the global market, it will take $1 trillion to convert the entire vehicle market. as long as Tesla nails it's product as better than an ICE it will be decades before EVs of that quality start competing with each other rather than simply taking over from ICE.

2. Can they? there is every indication that Tesla is at least 3 years ahead of other automakers in technology. I could go in great detail in another comment, but this is plainly evident, and recent information I've come across is suggestive that Tesla has competition walled off via patents for far more than 3 years.

3. Do they want to? as I said the global auto market will go form ~80 million to 100 million between now and 2020. we both see Tesla getting to roughly 1 million vehicles per year in 2024.

Why and how can leadership at the incumbents convince themselves and their boards to spend billions chasing perhaps 1 million in sales when that money could go to defending and growing market share in the 100 million vehicle ICE market? why not spend that money competing for the 20 million in incremental volume rather than taking a leap into a technology you have 0 experience in to try to maybe a decade later get up to a million vehicles per year.

point 1 alone is the main point, point 2 is a very solid back up, and point 3 is simply icing on the cake.

there's no need for you to remodel lower margins. are you starting to see why even value investors like Tesla?

Steven H said...

ps I have a strategy by which of you can get exposure to Tesla at far better value than simply buying here at $220. I'm not comfortable posting it on a blog, but if there's a means to email you privately, I'm happy to share it... (if your reworking your numbers convinces you to invest... and you promise to write that up in a blog ;)

Anonymous said...

Aswath,

Thank you so much for posting this. I thoroughly enjoy most of your musings on markets and really enjoyed this read. I am not yet able to understand the bulk of the nitty gritty in your valuation spreadsheet, but i hope one day i can. Im slowly watching your videos and learning much. Thanks for the free knowledge and insight you give to the world.

Ted Lim said...

Hello Professor Damodaran,
I’m back again. First off, for all the Tesla fanboys (I am one myself), don’t get all riled up. Financial valuation is just one aspect of investing. If valuation was proven 100% true, then anybody who knows math and can work a spreadsheet can make money. If this were really the case, equity markets would dry up because nobody would move because they all want one price. It goes back to the basic premise that the stock market is a reflection of investor confidence-- confidence that is determined by so many different things. Respectfully, I go for a fundamental analysis approach with numbers as a backup (crazy for some, but its worked for me). Back when Apple was on its death bed, no valuation could justify investing in it. It’s all about future growth. This is probably why so many people are telling you to drive the Model S, and you will buy the shares. I tend to agree with this, but from a pure numbers perspective I will agree that the hard valuations make it difficult to buy, but it’s all about the stories about the future that matter. You even said this company is in its growth stage, for me this is a strong indication that valuations don’t carry as much weight.
Furthermore, there is so much progress that should be looked at. This company is a little over 10 years old. It’s making vertical integration work, filling orders, ramping production, growing cash, and increasing sales/margins at the same time with ONE PRODUCT in the portfolio. No other auto company has done this before—I repeat NONE. Recently, I tweeted to Doug Kass of Seabreeze management who, like many, claim that Tesla is overvalued. My question to him was, what is fair value? At what price do you get in? The trap goes both ways. I believe his strategy was long GM, a company who has been bailed out twice and is going to lose future cash flow because the products they churn out just aren’t good enough.
I acknowledge that other companies have gotten into the battery “game,” but one needs to realize that they are taking starkly different approaches and have different intentions that lead to inefficiencies/subpar products. Most products are there for experimental purposes or are regulatory fillers. It’s widely known that Tesla is making battery packs for SolarCity and that the Model S will one day feedback energy into the grid (in fact the capability was there since the Roadster, but Tesla wants to make it perfect). There’s huge potential as an OEM like you stated in your last blog post, but for now no company is really taking it seriously or are just too culturally risk averse (I’m looking at you Toyota) to put all its eggs in one basket (Li-On batteries). So…Tesla stands alone. It will continue to grow its sales, margins, quality, and product portfolio. Long story short, valuation is just one piece of the mysterious puzzle called investing. Investors and commenters need to take this into account before whipping out the pitchforks and torches.
-Ted

Anonymous said...

Hello,

Always a pleasure to read your analysis. I'd appreciate if you could address issue of massive money printing by the Fed in your valuation.

On the one hand stocks, and TSLA particularly, may look overpriced. But on the other hand, USD depreciated (or is expected to) so significantly, that investors are willing to give more USD per stock.

Perhaps, you capture currency debasement in the discount rate and/or long-term growth rate, and it would be great to hear some explanation.

Best,
George

Anonymous said...

Aswath, I notice that in your valuation model: when you change your perpetual growth rate assumptions while leaving return on capital equal to cost of capital, the change in growth rate does produce a slight change in value. Going from 2.75% to 3.75% perpetual growth produces an extra 2 dollars or so of value per share. Theoretically under these conditions the value change should be zero. What explains this slight friction with the theory and model output?

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Anonymous said...

I think this is a great analysis. And I think there is one more point to consider. This is the fact that the competition is not sleeping. And the likely competition is a deep pocketed collection of big names like BMW.
BMW has just came out with their electric car in Germany and apparently you have to wait 6 month to buy one!!!.
If this is going to be successful they are going to bring more and more models out which either slows TESLAs sales or margins.

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Smart Money said...

Dear Dr. Damodaran,

Please ignore and stop responding to Steven H. He is clearly so enamored with his own research that he has convinced himself that he is right and anyone who disagrees is wrong. He won't even consider how extremely unlikely it is for a capital intensive manufacturer like Tesla to produce ROC of 40% to 50%. And he is absolutely convinced he is right despite the fact that making projections far into the future have proven to be notoriously wrong. You and I both know what happens to investors with Steven H's destructive behavioral flaw.

Remember the dotcom bubble when everyone said Warren Buffett was washed up and true value investors were forced to close shop? Who was right in the end? Us value investors have to stay convicted in our approach.

Tesla is clearly overvalued by every rational measure. You are doing a wonderful job educating those who us who are open minded. But please don't waste your valuable time on those who cannot learn. Remember the old proverb: "He who knows not, and knows not that he knows not, is a fool. Shun him."

Thank you,

Smart Money

Steven H said...

Smart Money,

an amusing, if completely distorted response.

1) "making projections far out into the future have proven to be wrong."

Aswath choose the timeframe of 2024, not me. my main valuation model is based on 2017 and 2020.

2) "absolutely convinced he is right."

I assume that I do not have certainty. that's why in my own models I add a scenario for a fumbled execution. I also such a fumble scenario to Aswath's base scenario. as you'll note in my earlier comments I put in a 20% likely scenario of only achieving half the earnings of the scenario Aswath had set forth.

3) "Remember the dot.com bubble?"

I remember it myself. In the late 1990s I consciously sought out an industry unrelated to the internet with high growth potential. I zeroed in on biotech, and bought Celgene in 1999. it worked out very well.

As to Warren Buffett. I've watched countless interviews and read a slew of articles about him. One thing I've learned, wait for your pitch. That is, it is extremely rare that I think I can have a good picture of the value of a company. It takes a tremendous amount of time and effort before I consider the probability that I'm right about a company to be worthy of my investing in it. Mark my words Smart Money, PROBABILITY I am right not "CERTAINTY", and a lot of time and effort in gaging this. I spent 3 months in 2012 seeking reasons NOT to invest in Tesla, in a conscious effort to avoid any romantic alure to repeat my success with Celgene from influencing my rational analysis.

I am anything but convinced of my being right about my ability to choose stocks. I have invested in exactly two stocks since 1999, Celgene and Tesla. Family and friends continually ask me about other stocks, and I continually say as I've heard Buffett say, "it just doesn't work like that... I can't simply look at any stock and decide whether it is a good value or not" (paraphrasing).

BOTTOM LINE, I get that you do not like what I have to say, and you want to persuade Aswath not to like what I have to say, and that's okay by me. But these feelings of yours are completely divorced from the value proposition of TSLA and the value proposition of my contributions to this blog.

Anonymous said...

Dear Steven,

A 50% return on capital is an absurd assumption. So is discounting what would be one of the great growth stories of all time at 10%. Please show me a manufacturing company earning 50% ROC. If you can't and still believe Tesla will be earning these returns, please reread the second sentence about discounting this miraculous scenario at a 10% rate.

Yours truly,
Anonymous

Anonymous said...

Analysing numbers is pointless. I suspect the vast majority of the bulls did not check any valuation number. It does not matter anymore for them. Then they will lose it all.

KV said...

I have to disagree on the probability of failure to be zero. Why? Tesla has a single plant that will be producing electric cars for coming five years or more. Tesla has to build another assembly line somewhere in middle of the USA.

I no longer hold position in Tesla. I would reconsider investing again if it came down to $65 level, as was estimated in Sept.

leomaniac said...

Hi Professor,

Just a small point on the valuation. This is clearly a stock which offers value through capital gains rather than true cashflows (read dividends for stockholders). This is also substantiated by the fact that even your valuation ascertains a terminal value, which even on present value basis is around 211% of the total valuation. This seems extremely high to me. That the company would have access to over USD 18 bn of funds in the next 10 years without generating positive FCFF inherently assumes that the company would have access to cheap capital.....We should also factor in a period of lower reinvestment say after 3-4 years, when the present bubble is expected (by me of course!!) to go bust.

So my revised assumptions are 50% growth rate in revenues for year 5, thereafter 10% decline y-o-y settling at 15% in year 9 and I am OK with the terminal assumptions of 2.75%. Thereafter I have assumed that due to consolidation there shall be higher focus on margins and hence the company shall be able to deliver a wee bit better operating margins in these years (post the bust!!).....

This results in a valuation of USD 87/Share.

This still does not solve my problem of high terminal value as % of PV of valuation. I guess using a longer period of projections before jumping to Terminal value could help

What are your thoughts on this...

Aswath Damodaran said...

leomaniac
Capital gains is not separate from cash flows in a DCF. It is the value of expected cash flows at the time of sale. In fact, there is not unacceptably low or high proportion for terminal value in a DCF. With a young, growth firm that needs substantial investment to grow, the terminal value will be 150, 200 or even 300% of value. Without knowing what margins you are assuming after year 10, I cannot really agree or disagree with the assumption.
As for why the terminal value still changes when the growth rate changes (even though ROC = Cost of capital), it is because of an assumption of convenience that we make where reinvestment occurs concurrently with growth. It should lag growth by a year.

Anonymous said...

hello Proffesor
Big fan ..I always loved the anecdote you give so here is my attempt to contribute one anecdote that is linked with Corporate finance & Valuation. Its from a Movie ( WORLD WAR) & I am sure you will find it interesting & I hope you will catch my drift.
---10th man theory, the God of devils advocate---
Its a scene from the movie called World war. The snippet is just about 3 minutes am pasting the link below just to give you a background .It’s a Zombie movie, In this movie there is a outbreak of Zombie pandemic that is toppling armies and governments, and threatening to destroy humanity & no one has any idea where this all Zombie pandemic have started & the 'world is turning into a Zombie' .In a race against time Brad pitt (Hero/savior) is allotted the responsibility to trace the source & to find the antidote . Incidentally he gets an Information that Israel is the first country to know about the outbreak & have been building big walls to protect them from zombies.thus makes them the suspect ( who have created the zombie virus) . So looking for clues Brad Pitts reaches Israel
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YOUTUBE LINK http://www.youtube.com/watch?v=AcNK7M2eCI4
Proposition
1 It will be great to apply 10th man theory in board meetings.
2 I think the 10th man just look like the Last lemming .
There are other propositions you can attach to the theory but for me every time I browse you website I feel like you have opened the gates & have let people in to learn the mysteries of finance

Ranjit

Anonymous said...

Enjoyed the post immensely Professor. Love your work.

I think I am getting my head around this valuation stuff now, consequently would like to propose an additional element to your model. It applies particularly well to Tesla.

What I do is come up with what I have called a BSM ratio (this stands for b8ll9shit meter). In Tesla's case, Elon Musk I would say, & this is only my own personal input you understand, talks 95% pure BS. What I then do is get the valuation produced at the end, & multiply it by this BSM ratio (a proxy for poor quality of earnings?). This would give me a value of 5 bucks roughly which is what I would buy the stock at.

Anand Raj

PS please feel free to use this concept in future lectures as I think I am onto something here ..

leomaniac said...

Hi Prof,

Thanks for your prompt response..

Actually I would like to clarify my post

a) When I say Cap gains and Dividends I meant how the stockholder looks at this stock. Since the FCFF is -ve (resulting in -ve FCFE) the stock shall not provide any dividend to the investor in the first 10 years...So only way the Investor makes money is through price appreciation due to +ve cashflows coming closer on PV basis. The cap gains was not from perspective of DCF, it was more from perspective of how the investor should look at the security...

2) What about your view on whether such a high investment is possible over the 10 year period...An investment of USD 18 Bn would mean Equity investment of around (7-9 Bn)

Thanks

Anupam Misra

Anonymous said...

Prof, your terminal value calculation says that PV of terminal value = $34,902.68 million, and I note that book value of invested capital at year 10 = $51,019 million.

I also note that you have set ROC = Cost of capital in which case PV of terminal value should have been equal to book value, i.e. $51,019 million.

The calculated PV of terminal value is lower by $16,116 ($51,019 less $34,902)million.

How come ROC = Cost of capital is value destroying? The company is earning its cost of capital.

Where is the catch?

regards

PENNY STOCK INVESTMENTS said...

I cannot unerstand all the talk about tesla. The company has just one make of car. Electric cars have been around for a very long time but the technology has yet to compete with gas powered cars. Using natural gas as fuel for cars seems like a much better idea.

Aswath Damodaran said...

I will write a post on reinvestment, since it is such a central assumption in valuing young growth companies. On the question of terminal value being equal to book value, that is true but it is ten years from now. The present value of that number today will not be equal to book value.

Anonymous said...

Thank you Prof, for the response. You are right, I missed the point that $51,019 is the terminal value 10 years from now.

However, now we have 2 choices of using year-10 terminal value: 1) $79,664 which is based on revenue and margins, and 2) $51,019 which is based on book value. Which one would be better - is either choice ok?

Thanks again.

I look forward to your post on reinvestment.

Vic Reeves said...

Wow, this was quite thoroughly written, and the topic you've chosen is right on spot.
Though I agree with Aswath that price is definitely not the same thing as value, I still enjoyed your post.
Keep writing, I really like reading your blog!

Aswath Damodaran said...

The terminal value is $51,019 only if you assume that all existing investments also go to earning their cost of capital. I am not assuming that. I am assuming that new investments after year 10 earn the cost of capital, but that earlier investments continue to generate excess returns.

Anonymous said...

Got the point. Thank you.

Steven H said...

Aswath,

Thanks for taking the time to read and consider what I've shared about the scale of Tesla's needed capital expenditures over the next decade.

As to Tesla's ability to maintain margins in the coming years. If you are interested, I am happy to share with you the fundamental reasons they will not be pressured on margins for far further into the future than one might otherwise think (in fact, due to Musk's mission orientation of expediting the advent of electric vehicles, I believe there will be a considerable time period when Tesla voluntarily sells the majority of its vehicles at a lower price than what supply and demand economics would otherwise command for them) .

Because I've researched the pricing of goods that will affect their margins from a fundamental perspective as the years go by and the EV market expands (supply and demand for their raw materials and supply and demand for their product), my analysis is quite lengthy for a comment here... and frankly, would be a bit presumptuous to think you or your readers want to read such a lengthy presentation.

If you do have interest in reading my analysis indicating the vey high probability Tesla's margins have a moat reaching far into the future, I'm happy to send you an email (of course, if you'd like me to post it here, I will, though it will take quite a handful of comments!).

Kind Regards,

Steve

AT said...

As usual, informative and humble article from Prof Damodaran-- thank you!

Steve,

In Tesla's own words (per the risk section of the 10k):

"Most of our current and potential competitors have significantly greater financial, technical, manufacturing, marketing and other resources than we do and may be able to devote greater resources to the design, development, manufacturing, distribution, promotion, sale and support of their products. Virtually all of our competitors have more extensive customer bases and broader customer and industry relationships than we do. In addition, almost all of these companies have longer operating histories and greater name recognition than we do. Our competitors may be in a stronger position to respond quickly to new technologies and may be able to design, develop, market and sell their products more effectively. Additionally, we have not in the past, and do not currently, offer customary discounts on our vehicles like most of our competitors do.
We expect competition in our industry to intensify in the future in light of increased demand for alternative fuel vehicles, continuing globalization and consolidation in the worldwide automotive industry. Factors affecting competition include product quality and features, innovation and development time, pricing, reliability, safety, fuel economy, customer service and financing terms. Increased competition may lead to lower vehicle unit sales and increased inventory, which may result in a further downward price pressure and adversely affect our business, financial condition, operating results and prospects."

Now, I get the argument of TSLA having advanced technology right now but not the one that assumes the competition is so naive to sit idly by as they see mkt share significantly leak on a continuous basis. This kind of ties in with the outrageous ROC assumptions. I wonder if the big boys are letting Tesla be the guinea pig here, only to seriously commit capital when they see more numbers and less hype?

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Anonymous said...

Great article! But using Audi's revenue and Porsche's margin to value Tesla may not be an appropriate measure. Since Tesla, in a way, is a tech company, rather than an automobile company.
I'm looking forward to your next update on Tesla.

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Steve S said...

Lively discussion and quite interesting. I'm torn between Steven H and the Professor. On the one hand, history would agree the Professor is quite prudent in suggesting the 40-50% ROC for a manufacturing company (albeit a hybrid tech/manufacturer) are unlikely achievable and certainly not sustainable. On the other hand, TSLA has produced a paradigm shifting technology and may benefit from being an early entrant to a highly capital intensive (high barrier to entry) industry. The valuation case can be made for both. I am stuck in the middle even using conservative industry (auto) assumptions (5yr Avg) on margins and reinvestment, finding the stock fairly valued (on the low end) to worth roughly $300 on the high end.....My answer?, I scheduled a test drive!!!

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Anonymous said...

Professor, congrats for chossing such a contradictory case and bringing such an interesting discussion. After doing my homework and reading this passionate comments of some holders, I am positive am ready to short this stock. Good luck for those that are holding it expecting the company to reach a 40% ROIC in 2024. In the mean time, I wil short this idea and buy other stocks that do not need to deliver such an improvement. Steven, I may borrow some stocks from you. Good luck to everyone.

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Anonymous said...

an american company with significant cost will have a higher or a lower PE than a european company? please elaborate

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TL said...

Hi, another great post. I m one of your long time followers. This post successfully shows that rational/'value investors can arrive at extremely different assumptions especially for Growth companies.

I valued put options of Tesla using the put-call parity which I learned from NYU 's Future and Options class. My findings show that all out options all significantly overvalued. Though i m aware of the shortcomings of the BS model, but I don't believe that would explain such disconnect. Speaking the BS fail to account for the High probability of either direction of future stock movement?

TL said...

...'put ' options are significantly overvalued....'Does ' the BS model fail to account... sorry for types earlier

Anonymous said...

Professor, your time and insights are truly appreciated. Aside from the Tesla valuation and mechanics of buildling up the cost of capital, I was hoping you could help deepen my understanding on the statement, "The decline in the cost of capital is more the consequence of change in the overall market environment, where the rise in overall stock prices in the last few months, has lowered the equity risk premium."

In my mind, I align the cost of captial with rate of return; and while I can see this multiple ways, my first instinct is that a run up in prices would almost have an opposite impact to the ERP, given opportunity costs, etc. Strictly looking a value implied by the DCF, it makes sense a higher value (similar to a run up in stock prices) can be calculated using a lower discount rate.

Let me know your thoughts. Again, your time is much appreciated.

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Anonymous said...

Hey its new world economics.

Look at amazon, it took a decade and over $1 Billion dollars to get it going.

And its still not that great fundamentally, neither is telsa but what tesla is doing is creating a conversation about the direction of the automotive industry- and if people want to put capital into that conversation via stock then go ahead.



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