Wandering Through the Noise

Tesla, the brainchild of Elon Musk, has surpassed GM and Ford in market cap. Tesla’s stock price is up nearly 59.8 percent since the beginning of the year to more than $340 per share, while the company’s value is sitting around $56.57 billion.

Looking at Tesla’s most recent yearly performance data, three key metrics stand out: they have only delivered 76,000 vehicles, their earnings were in the red again at $-674,000,000, and they have nowhere near the infrastructure needed to meet their growth projections.

With no growth factored in, Musk is the first to point out that Tesla is absurdly overvalued — though, luckily, value is not derived from the present but instead, from future opportunity. Nearly all of the $56B that investors have driven into Tesla’s market cap is found in it’s terminal value. The sales projections Musk has outlined form a dreamy growth story that has allowed investors to justify it’s sky-high market price and continue to push prices higher and higher. Each time Tesla reaches another “impossible” milestone, the stock price grows with fury.

The extent to which Tesla is overvalued based on its current performance is highlighted most clearly through its EBITDA multiple that currently sits at a frothy 129x. While EBITDA multiples like these occasionally appear on the public markets, it is incredibly rare to see from an auto manufacturer. An industry that consistently has a 10x average.

With these metrics in mind, what type of performance will we need to see from Tesla over the next 5 years for its current value of (56.57B) to be maintained or pushed higher?

There are few scenarios in which DCF models suggest this could occur. The most important factor is found in Tesla’s revenue growth. The company must bring its operations to scale and reach its 50% year over year growth targets. If successful, revenues would break the $11B mark by 2018, while still reporting significant negative free cash flows. Keeping with managements projections though, if Musk is able to keep this red hot 50% growth pattern churning two years longer, for the first time in 2019, the company would churn positive free cashflows north of $1.5B.

Growth numbers like these don’t come without the reciprocal cost of slashing per vehicle margins. Many analysts believe this strategy will ultimately bankrupt Tesla. I, on the other hand, believe Musk is nearly copying the late Henry Ford. While some profit must be earned on each unique car, history has shown risking margins for growth can pay off massively. In the early 1900’s Henry Ford was criticized for exercising this very practice, but sacrificing profit margins to bolster sales became a classic Ford maneuver. Mr. Ford slashed prices on the Model T in 1912 to $575 from its prior price tag of $825. This massive price reduction cut Ford’s net profit per vehicle from $220 to $99. Management feared this would crush free cash flows but the exact opposite result ensued. Over the next 12 months, sales exploded from 78,440 to 248,000 vehicles sold, growing net income by 800%. Musk is cutting vehicle prices on a similar trajectory to Mr. Ford but projecting larger growth. While this larger growth could be justified through the bigger population and larger market size, it is certainly an ambitious goal.

If we are willing to assume that Musk’s belief that demand will soar when prices of his Tesla’s drop, there is one more big obstacle standing in-between the company and a fully justified $56.5B valuation: can he really build this may cars so quickly? To date, the company only has the capacity to build 200,000 cars per year. In order to stay on track with projected demand, Tesla will need to increase capacity 2.5X. A goal that in the car manufacturing business is no easy feat. If Tesla can successfully increase its capacity to a level that meets it’s production goals, it will be among the most productive factories ever built.

Wildly ambitious? Yes. Impossible? No. If any modern-day entrepreneur is right for the task it is Musk, but to make the dream a reality and deliver on its current $56.5B valuation, consumer preference must continue to crave its cars. Only time will tell if Tesla is here to stay or it is just another 2000’s tech bubble dream that will disappear from the masses faster than it arrived.