How to value Tesla stock?

Tesla’s stock price continues to be one of the most controversial topics for investors.

Bulls tend to think it’s still undervalued while Bears think it’s ridiculously overvalued and often go as far as comparing Tesla's hype to the Tulip bubble of Europe in the early 1600s.

So where is the truth of the matter?

Followers of my work know that I’ve been very bullish on Tesla for a while now and have a substantial part of my personal portfolio invested in Tesla.

So what am I doing with my position? Have I sold after the recent runup? Am I holding? Am I buying more?

I’m going to answer these questions in the following article.

Tesla's Valuation

Tesla's sales revenue, as of the second quarter of 2020, came from the following business segments:

Tesla Revenue Breakdown

The valuation for Tesla I’m going to share with you assumes Tesla will only make money from cars.

Meaning we’re excluding Tesla’s energy generation and storage businesses entirely from our calculations. 

Having said this I think Tesla’s Energy generation and storage businesses have the potential of becoming just as large, if not bigger, than its automotive business and so does Elon Musk, CEO of Tesla, as per comments he's made in a number of previous earnings calls.

If we can come up with a compelling case for investing in Tesla even without the Energy generation and storage businesses, then a Tesla investment which naturally includes these businesses becomes a no brainer in my mind.

To estimate the value of Tesla based on its automotive business alone, we need to have estimates for the following:

• How many cars will Tesla produce?

• How much profit will Tesla make per vehicle?

• What multiple of profit will investors be willing to pay for every dollar of profit that Tesla makes?

How many cars will Tesla produce?

Tesla has a 500,000 vehicle guidance for 2020.

Depending on who you ask, estimates for the growth rate of Tesla over the next 3 to 5 years range from 30% to 50% annually. 

Elon Musk has mentioned on several occasions that he is aiming for a growth rate in excess of 50% annually.

Indeed, if you average out the growth rate that Tesla has achieved annually since 2014 it’s around 60% annually.

Based on this, I think a 40% annual growth rate of Tesla vehicles produced and sold over the next 3 to 5 years is a reasonable assumption and that’s what I’ll use in my model.

How much profit will Tesla make per vehicle?

I expect Tesla's margin per vehicle to be much higher than that of any internal combustion engine (ICE) vehicle.

This is because Tesla doesn’t only sell a car, it sells the software upgrades for the car, most notably Full Self Driving (FSD), and software has incredibly high margins. 

Not to mention Tesla insurance which I expect will further add to Tesla’s margins.

So what profit margin % can we expect from Tesla?

As per Wright’s law, the costs of electric vehicle manufacturing are expected to decline substantially.

For those who are unfamiliar, While studying airplane manufacturing, Theodore Wright observed that for every doubling of airplane production the labor requirement fell by 10-15%.

Wright’s Law simply states that for every doubling of production, costs tend to fall by the same rate.

Wright’s Law has been found to accurately forecast cost declines successfully across many technologies.

If costs were to fall in line with Wright’s Law, Tesla’s auto gross margin could approach 40% in the next five years.

If this is true, we’re looking at a EBITDA profit margin of around 25% per vehicle.

If the average sale price of a Tesla vehicle is $40,000, a 25% profit margin means Tesla will make around $10,000 in profit per car it sells.

What multiple of profit will investors be willing to pay for every dollar of profit Tesla makes?

The company I find most analogous to Tesla is a younger Amazon.

I say this because Amazon is an innovative company that has prioritized growth over profits since inception. Additionally, Amazon has managed to build a rather substantial moat around its business through a combination of highly sophisticated technology and logistics infrastructure. All things I see Tesla doing today.

Since achieving consistent profitability in 2015, the lowest PE ratio Amazon traded at was around 75.

Amazon PE ratio

Currently, Tesla’s PE is around 1,000.

If Tesla is able to continue to capture investor’s imaginations with new products while maintaining a growth ratio of at least 40% annually, I expect Tesla will not trade for a Price/Earnings ratio of less than 100 for the next 3 to 5 years.

Having said this, let's be conservative.

After all, the market has been in the midst of one of the longest bull runs in history and this is bound to end at some point, so let’s assume a PE ratio of around 50 for Tesla in 2025.

So now we have our three assumptions:

1- A forecast for the number of cars Tesla makes and sells based on a 40% annual growth rate.

2- Profit margins of 25%

3- PE ratio of around 50

Using these assumptions, my Bear case for Tesla in 2025 is a price of ~$1,164 (see model below for details).

Tesla valuation model

Regarding the above prediction keep in mind this is the Bear case based on the following:

1- We’ve completely ignored revenue from Tesla batteries and solar panels which have the potential to become as large as their automotive business. 

2- We’ve completely ignored the potential for a Tesla ride-hailing network which may increase the value of each Tesla vehicle by 5 times since the utilization of each car will go from 12 hours a week on average to around 60. This would dramatically increase Tesla’s profit margins and by extension the stock price.

Despite our conservatism, you still come out with a stock that will likely return at least 30% return every year for the next 3 to 5 years. Based on this valuation, I find that Tesla, at a current market cap of ~ 350 Billion is reasonably priced and still offers an opportunity for the investor to buy.

How I personally manage my Tesla position:

Simple...

I set a target weight for Tesla in my portfolio and manage my investing and withdrawing of funds so that the weight of Tesla reverts to the target I set for it.

Currently, the target weight of Tesla in my portfolio is set at 70%.

When Tesla's weight in my portfolio deviates from the 70% target I set for it, I remedy the deviation whenever I'm buying into or selling out of my portfolio.