Valuation of the week 1: A Tesla Test

Aswath Damodaran's picture
Rank: King Kong | 1,612

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!

Comments (21)

Sep 9, 2013

Interesting read, thanks for posting

Sep 9, 2013

Great insights. Thanks for the post.

Sep 9, 2013

Great post, very insightful. I like your method, makes a lot of sense to me, and your numbers seem reasonable. Of course, it is always hard to say what the future will bring for them, but I would tend to agree for the most part. I'm a little optimistic in terms of what they will be able to accomplish with margins, as I think they are very much focused on how to make the cars more efficiently, not just making efficient cars. The Model S, for example, is on a platform that will also likely be used for the Model X (upcoming SUV), and this saves a lot of cost. If they can continue to platform-share, and use the same electrical and drivetrain components in many different models (which they should be able to do), I can forsee quite a large operating margin, as the marginal cost of additional models in the range will be very low compared to what some manufacturers need to do. But who knows. It will be very interesting to see what happens.

"When you stop striving for perfection, you might as well be dead."

    • 1
Nov 24, 2013
EvanM:

Great post, very insightful. I like your method, makes a lot of sense to me, and your numbers seem reasonable. Of course, it is always hard to say what the future will bring for them, but I would tend to agree for the most part. I'm a little optimistic in terms of what they will be able to accomplish with margins, as I think they are very much focused on how to make the cars more efficiently, not just making efficient cars. The Model S, for example, is on a platform that will also likely be used for the Model X (upcoming SUV), and this saves a lot of cost. If they can continue to platform-share, and use the same electrical and drivetrain components in many different models (which they should be able to do), I can forsee quite a large operating margin, as the marginal cost of additional models in the range will be very low compared to what some manufacturers need to do. But who knows. It will be very interesting to see what happens.

Wow, that was rough.

-KermitBeee
gurmitbhatia[.]com

    • 1
Nov 24, 2013
KermitBee:
EvanM:

Great post, very insightful. I like your method, makes a lot of sense to me, and your numbers seem reasonable. Of course, it is always hard to say what the future will bring for them, but I would tend to agree for the most part. I'm a little optimistic in terms of what they will be able to accomplish with margins, as I think they are very much focused on how to make the cars more efficiently, not just making efficient cars. The Model S, for example, is on a platform that will also likely be used for the Model X (upcoming SUV), and this saves a lot of cost. If they can continue to platform-share, and use the same electrical and drivetrain components in many different models (which they should be able to do), I can forsee quite a large operating margin, as the marginal cost of additional models in the range will be very low compared to what some manufacturers need to do. But who knows. It will be very interesting to see what happens.

Wow, that was rough.

You seem to be nothing but a troll.

Care to elaborate?

"When you stop striving for perfection, you might as well be dead."

Sep 9, 2013

Great post. Thanks!

I'd imagine the margins would be lower as their strategy is to ultimately produce mass market vehicles rather than just luxury cars. I think that their third generation vehicle after Model X is said to be only around half the price of Model S.

Sep 9, 2013
LAX:

Great post. Thanks!

I'd imagine the margins would be lower as their strategy is to ultimately produce mass market vehicles rather than just luxury cars. I think that their third generation vehicle after Model X is said to be only around half the price of Model S.

Great point. If they could do Porsche margins with Volkswagen volume...they're golden. That's of course a super-idealistic scenario, but not impossible if things go the right way for them.

"When you stop striving for perfection, you might as well be dead."

Sep 9, 2013

Great post. Remarkable that even though you forecast Tesla to be larger than Audi and to have operating margins way far above average, it is still far from a buy. It's difficult though, since Tesla could be 'Apple-like', meaning that they can achieve profit margins way above everyone else's. The company is clearly extremely innovative and its cars look amazing but the valuation doesn't lie. I'd never buy this stock at this price.

Sep 10, 2013

You realize this is syndicated right? I don't think he actually reads these forums. Can someone correct me if I'm wrong on this?

Sep 10, 2013
Xepa:

You realize this is syndicated right? I don't think he actually reads these forums. Can someone correct me if I'm wrong on this?

you are correct. i've forgotten recently to put a mod note in the post to mention to people that if they want to ask q's to post directly on his blog

WSO's COO (Chief Operating Orangutan) | My Linkedin

Sep 10, 2013

Great post! Awesome insight and an interesting point of view. Thanks.

I hope this is better than the last batch of shit you gave me. Produced more wood than Ron Jeremy. I don't want you to yell, "Reco!" anymore. Know what you should yell? "Timber!" Yeah, Mr. Fuckin' wood.

Sep 10, 2013

While well written, I can't help but see tethering all over this analysis. Because of the current share price, the professor assumes this manufacturer will have the volume of Audi in ten years? If the stock price was 30/share, I can't help but believe that the professor would have used Ferrari volumes instead of one of the more mainstream manufacturers.

This entire analysis already tells you the things that are obvious: this is a very risky investment that will probably lose you money, but it has a small chance of making you a shitload even from these levels. Running a discounted cash flow is virtually meaningless on a company like this.

Sep 10, 2013

A DCF is only meaningless for a growth stock like TSLA because of the valuation's high susceptibility to wide variances in assumptions. The professor effectively overcomes this limitation by using the monte carlo.

Sep 10, 2013

A Monte Carlo simulation is only as good as your inputs, which are complete wild ass guesses at this point. I don't think a Monte Carlo has overcome anything. This is like a wild ass guess squared.

Sep 10, 2013

I was thinking about investing in TSLA before I read this but having looked at the raw data for automotives I think I may have found a couple of better alternatives.. VW sitting at 4.6x PE and Audi at 6.4x PE, I would have thought much higher for these two given growth prospects in emerging markets. Thoughts?

Sep 10, 2013

I think the point is more that the assumptions are so generous, yet you can't even come close to the current stock price, therefore it is overvalued and you can see it much more clearly with the monte carlo simulation. The simulation gives you an idea of where the value is relative to the assumptions you make. So in a way it's working backwards, if you are being very optimistic and still can't reach the current price, then clearly it's not a buy. I'd say it's still a useful exercise

Sep 10, 2013

I think that's a reasonable argument for testing your idea to see how wrong you might be. I think it's still worth knowing that your assumptions could still be massively wrong even when stress testing them under what you believe to be realistically unattainable numbers. Which brings me back to the original point that you probably know the overwhelmingly most likely case is that you lose a lot of money by buying the stock, but if you're wrong, the valuation will be significantly higher albeit in a much smaller number of scenarios.

The most important part about what he says in this and the related article is that he is neither long nor short right now, which is a conclusion that I think is the most reasonable one to take given the current price and the unusual patterns in the stock (momentum, high levels of short interest, etc.).

Sep 15, 2013
globalmacro:

The simulation gives you an idea of where the value is relative to the assumptions you make.

Good point.

Sep 12, 2013
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