Many a slip between the cup & the lip: From forward value to value per share today

Valuing young, growth companies is never easy to do but it is well worth doing, partly because it forces you think through the business that the firm is in and what it is doing (or needs to do) to succeed. I know that many of you disagreed with my assumptions on the Tesla valuation and this post is not meant to refight that battle. There is one aspect of the Tesla valuation that I would like to focus on, not so much because of what it says about Tesla but for the more general lessons about what drives the value per share at young companies.

In the Tesla valuation, I made the judgment that Tesla would have Audi-like revenues and Porsche-like margins to conclude that the equity was worth $8.15 billion today. That puzzled a lot of people, since Audi currently has a market cap of $33 billion and that market cap would be even higher if the company commanded Porsche-like margins. So, why is my value for Tesla's equity so low today?

If you revisit my valuation and check the value that I have attributed to Tesla in year 10 (the year that I see them having Audi-like revenues and Porsche-margins), you will see an estimated value of $68.27 billion. To get from that expected value for a business in the future, estimated either using a DCF model like I did or by applying a multiple on earnings as many venture capitalists becomes a value today, you have to take into account the following “drags” on value:

1. Time value of money: Every finance/investments class begins with the proposition that a dollar today is worth more than a dollar ten years from now and that principle should not be abandoned when doing valuation. Thus, even if I take the unrealistic view that Tesla’s value in year 10 is guaranteed, I would have to discount that value back at the US T.Bond rate of 2.75% (at the time the valuation, used as the risk free rate) to arrive at the value today:

Estimated value for Tesla in year 10 = $68.27 billion

Present value of $68.27 billion @ 2.75% = $52.05 billion

Drag on value from time value of money = $68.27 - $52.05 billion = $16.22 billion

2. Business Risk adjustment: An uncertain dollar in the future is worth even less than a certain dollar at the same point in time, which is the logic behind using a risk-adjusted discount rate. In the case of Tesla, I used a cost of capital of 10.03% for the first five years, reflecting its mixed exposure to the automobile and technology businesses, and scaled that cost of capital down to 8% in year 10. The net effect is that a dollar in expected cash flow in year 10 is worth only about 40.65 cents today. Think of this as the compensation that you are asking for as an investor for the uncertainties and disappointments that will come over the next decade.

Present value of $68.27 billion @ 2.75% = $52.05 billion
Present value of $68.27 billion @ risk adjusted cost of capital = $27.75 billion

Drag on value from risk adjustment = $52.05 billion - $27.75 billion = $24.30 billion

3. Dilution/Reinvestment adjustment: Increasing revenues over time will require reinvestment. In the case of Tesla, that is the purpose of the sales to capital ratio of 1.41, requiring the company to reinvest a dollar in capital (in R&D, infrastructure, plant & equipment and acquisitions) for every $1.41 in revenues every year for the next decade. This reinvestment creates negative cash flows (for much of the next decade), which in turn will have to be financed with either new debt issues or new equity issues. I am assuming that much of the financing in Tesla will come from new equity (by assuming a debt ratio of only 2.6% in my cost of capital computation), which will raise the share count in the company. This is of course the proverbial dilution bogey man, and in the valuation, this is captured by the present value of the cash flows over the next decade. 

PV of terminal value discounted @ risk adjusted cost of capital = $27.75 billion

PV of expected cash flows @ risk adjusted cost of capital for next 10 years = $14.94 billion

Value of business after adjusting for the dilution = $ 27.75 billion - $14.94 billion = $12.81 billion

Drag on value from dilution = $14.94 billion

4. Failure Risk adjustment: Even the most promising growth companies face challenges to survival and don't have the wherewithal to survive a large shock either at the company level (a lawsuit) or at the macro level (a banking crisis, a severe recession). While I think highly of Tesla, I do think that there is  a residual risk of 10% that the firm will not make it, and if it fails, the proceeds it will get for its technology will be only 50% of the estimated value (since your bargaining position is shot).

Value of business before adjusting for failure risk = $12.81 billion

Value of business after adjusting for failure risk = $ 12.17 billion

Drag on value from failure risk = $0.64 billion

5. Net Debt adjustment: The equity investors in a business have to take into account the debt outstanding in the business, since they are entitled to only the residual claim. This can be partially offset by the cash balance that the business has, which has not been counted in the value so far. In the case of Tesla, the debt and cash balances from the most recent annual report yield a net debt value of $0.37 billion. (That may be outdated already since Tesla's cash balance has climbed and it has repaid its loan from the Department of Energy. However, the effect of updating this number will neither make nor break this valuation).

Value of business after adjusting for failure risk = $12.17 billion

Value of equity after net debt adjustment = $11.80 billion

Drag on value from net debt = $0.37 billion

6. Option overhang: The equity in a company has to be shared by the common stockholders in the company with employees (and others) who have options that have been granted to them over time by that company. With Tesla, this is a significant factor affecting the value of common stock, since the company has 25.06 million options with an average strike price of $21.20 (well below the current stock price). The value of these options is approximately $3.65 billion.

Value of equity after net debt adjustment = $11.80 billion

Value of equity after option overhang adjustment = $8.15 billion

Drag on value from employee/management options = $3.65 billion

Bringing together all of these adjustments into one picture shows the cumulated effect of all of these drags on value, reducing the estimated value of $68.27 billion in year 10 for the business to the $8.15 billion in value for equity today.

I don't intend to rekindle debates about Tesla's value but almost all of the arguments that I have heard from those who believe that Tesla is worth more than I do can be crystallized into one of these adjustments:

1. Operating value in year 10 is too low: If you believe that Tesla is capable of generating much higher revenues than I have estimated, while maintaining high margins, you are, in effect, arguing that the terminal value of $68.27 billion (that I estimated) is too low and that you think that Tesla will have a higher value in year 10.
2. Business risk adjustment is too high: Some of you have argued that Tesla's business model may expose them to less risk. While I don't quite understand the full details of this argument, it is a an argument for a smaller risk adjustment than the $24.3 billion than I have made. Note that even giving Tesla the cost of capital of a low risk US company (8%) all the way through results in a risk adjustment of $20.4 billion. In the same vein, you may not feel that there is any chance of Tesla failing and eliminate that adjustment as well. You may, of course, take the view that Tesla is a riskless investment and eliminate this adjustment entirely.
3. Dilution/ Reinvestment: This may be the area where there is the most room for disagreement. My assumptions about reinvestment are animated by my view that Tesla is an automobile company and that scaling up will eventually require large investments in plant and equipment. The counter argument that I have heard from some is that Tesla can develop a model where it licenses technology or focuses on power train/battery sales rather than car sales. That may very require less reinvestment than I have assumed and create much smaller drag on value. 

You may not believe me but I really have no desire to talk you out of investing in Tesla and I certainly have no interest in pushing the stock price down.  If you do make the choice of investing in Tesla, though, I would like you to engage in this debate about value and think through the assumptions that you are making and whether you are comfortable with them. You don't have to convince me. All you have to do is convince yourself that you are making a good investment.

Steering the discussion away from Tesla, this decomposition does provide some general lessons or propositions about investing in and valuing young companies. 

1. Be wary of per share values: While equity research analysts and investors are fond of focusing on earnings per share and other per share metrics, you have to be cautious about any per share values with young, growth companies, where the share count is a moving target.
2. Forward values are misleading: Another favored technique used by analysts in valuing young, growth companies is to forecast out earnings in a future period and applying a multiple to these earnings to estimate a forward value. That forward value is often used to back out the return you will make if you invest in the company today, at its current value. This misses the dilution effect that is part of investing in a young, growth company and the potential for failure.

In the months to come, I will value other young, high growth companies (Linkedin, Amazon and Netflix are on my list of must-do valuations) and I will try to present this terminal value decomposition with each of them.