The Euphoria of Growth Stocks
The last 3 years have been a very good time for the growth stocks. For many of the star companies, the old conservative valuation models based on book value and earnings yield are being replaced by the growth rate and future potential. The high P/S (Price to Sales) ratio shows that investors have many optimistic projections of the future growth.
As the history shows, investors tend to have very short memory about the financial history, and the euphoria of growth stocks often signals the end of a bull market.
Among all the growth stories, the story of Tesla (NASDAQ:TSLA) is one of my favorites, since I truly believe Tesla is likely to be a successful disruptor and may eventually take over the world. This is partly because there were no disruptors in the automobile industry in the past decades, and the existing players got too big and too slow on innovations.
However, investors often confuse the ultimate success of the company with a successful investment. Due to competition, the history shows many, many times that glamour companies often turn out to be bad investments, simply because the good story, if well known, will bring in even higher bids than its intrinsic value. Also, things rarely happen in the same way as expected.
The human brain has limited capacity, and it tends to focus on a couple of things at a time. The manic depression symptoms found in Mr. Market and the investors are understandable because our mind tends to focus on the recent news or a narrow perspective of the fundamentals at different times. When a story appears and focuses on the good side, people tend to be bullish and bid the price up. But when the recent news turns bad, they suddenly turn to the bearish side and take a loss quickly in order to sleep better.
That said, it is not a simple accusation to the other investors, because I am one of them. I have been guilty of swinging between the two extremes myself. For this reason, it has been important for me to keep a checklist of the high level bullish and bearish points, something I can check on at any time before I make a purchase/sale decision.
The Good Side
Let’s start with the good news first:
1. Take over the world.
As I mentioned above, I truly believe Tesla will likely “take over the world”. Although this doesn’t mean that Tesla will become the largest car company in the world, I do think it is likely to have the most loved car and the company will eventually get to the size of BMW, with about $100 billion revenue.
The innovative ideas and enthusiasm in the model design and all the advanced technologies, the innovative direct sales model, the efficiency in the manufacturing process, and the laser focus on user experience all give Tesla a huge competitive advantage. Other companies can be copy-cats, but it is very hard for them to match Tesla. This is mostly because the automobile industry is full of old players who are usually very slow on moving forward.
This industry has significant economies of scale too, in terms of the R&D needed and the brand name recognition required. It is also a capital intensive industry, as we have seen in the poor ROA (return on assets) of the industry. Ford, GM and BMW only have 3% – 5% ROA. Their ROE may reach 10% or more for now, but that is based on a good economy, low interest rate, stable revenue and loose credit. When these conditions no longer hold, we may find the growth of these mighty car companies are only destroying shareholder value. The more they grow, the more value they destroy.
All these mean that it is very hard for new entrants to enter. In fact, the only reason Tesla exists today is because it was not profit-seeking when it was founded! (Elon Musk estimated that there was only 10% chance of success when Tesla was founded.)
One relatively new player and close competitor is BYD in China. I have been a shareholder of BYD in the past too. The CEO of BYD (Chuanfu Wang) is very smart and had some great achievements too. However, in my own opinion, BYD is still not a match to Tesla in terms of innovation and model design. It is great in its own way, and it has easy access to the cheap human capital in China, but so far it doesn’t seem to be a threat to Tesla yet.
2. Direct Sales Model and Low Working Capital.
Tesla’s innovation goes to the sales model too. The direct sales model not only saves the distribution cost, but also reduces the working capital. The whole system also becomes much more efficient. In the US, I believe the regular consumer experience with car dealerships can be ranged from poor to awful. So it actually helps on improving the customer experience too.
Dell’s success mainly came from the direct sales model, and it actually had negative working capital because of this. This advantage may not reflect on earnings, but small investors usually don’t know that in terms of investment returns, this difference is huge. In other words, the cost of any capital (whether it is current assets or fixed assets) is not to be ignored.
3. New innovations and ventures.
When Apple first announced the iPod, people who liked it would use iPod and Mac sales to value the company. In hindsight, we know that valuation would have greatly undervalued the company because they should have considered the possibility of further new product releases, such as the huge successes we have later witnessed in iphone and ipad.
Similarly, Tesla may not stop at EV. The opportunity at autonomous cars, batteries, and who knows what other technology could be some pleasant surprises to investors later.
4. No demand problem in the long term.
Despite the fact that Elon Musk continuously said Tesla has no demand problem, many speculators always worry about the potential demand saturation. In my opinion, Tesla doesn’t have a demand problem right now, since it still has a lot of tools it hasn’t used to boost demand, such as advertisement. Also, the hesitation of the wealthy is related to the lack of charging stations which are being built up gradually. The information diffusion also takes some time to reach its peaks (this translate to Tesla not yet being seen as a “fashion” product in many areas.)
Eventually, the luxury car sales will saturate at some point, but by that time, we may have the 3rd generation model coming out. The price/value ratio with that model will be hugely attractive to the average consumers, and it would be a time for Tesla to really take over the world.
Right now, Tesla only have two hurdles: price and charging. The 3rd generation model will address the first problem, and the charging network are gradually being built up. This is a classic “network effect” problem, as more charging stations will allow more EVs and more EVs will bring in more charging stations. The adoption of EVs are already picking up in the US. We may soon reach the tipping point of that network effect.
Saying “no demand problem” doesn’t mean the demand will always keep up with the pace of the production growth, or there will be no short term demand problems at all. From time to time, we may see the demand doesn’t keep up with the expectation or production, but in the long term, it is likely that the peak demand is large enough to allow Tesla to reach the $100 billion revenue mark.
5. Better Economies Of Scale.
While Tesla has already reached a certain scale, as it increases the scale even further, there may be additional cost savings and possible margin expansion. It is hard to provide an accurate analysis on this, but a couple percentage points of margin expansion could cause a big change in the valuation.
The Bad Side
1. Capital intensive industry.
I have seen arguments like Tesla should be classified as a high-tech company because it mainly focuses on R&D. While this argument is not completely unreasonable, we have to be aware that the high tech companies could have quite different economics.
The key difference between the high-tech world and traditional industries is the difference on variable cost and capital needed for fixed assets.
Traditional industry (manufacturing industry) produces goods with raw materials. So the gross margin is low, and variable cost is high. It also tends to require significant up-front investment in fixed assets, such as factories and distribution infrastructure.
On the other hand, for the high-tech industries like the software industry, the variable cost is low: selling one more software license or installation CD costs almost nothing. The up-front investment is mainly on R&D in the software industry, which is certainly a significant cost, but both the gross margin and the profit margin are very high, once the company has reached a certain scale.
Comparing to the software industry, the high-tech hardware companies such as Apple tend to have lower gross margins, but Apple outsources much of the manufacturing to the third party suppliers. Therefore it doesn’t need a lot of investment on factories, which makes it easy to scale up and scale down.
On the other hand, if the hardware company is producing regular PCs like HP or Dell, once the product becomes a commodity, it looks more like a traditional industry than a high tech industry.
In this sense, although Tesla’s success mainly comes from its focus on R&D, the capital intensive nature and low margin nature do not change much. It requires huge fixed asset investments on manufacturing facilities, battery factories, and charging stations. Therefore, although Tesla is quite different from the other car companies, it should still be classified as in the traditional auto industry.
So far, Tesla has $2.6 billion in fixed assets, mainly in factories, charging stations, service and retail centers. Based on what I have seen from BMW, the fixed assets are close to its annual sales. If so, a 10% profit margin means the return on assets is roughly 10% too. This is certainly much less attractive than the most companies in the high tech industries.
To be fair, Tesla may be more efficient than BMW in terms of the manufacturing process, so maybe it can achieve better ROA and ROIC (Return On Invested Capital), but it may not be a lot better.
In fact, we have to assume its ROA is better than 10%, because otherwise, the growth will not provide any economic value at all, assuming the average cost of capital is 10%.
The following question would be: where will the capital come from? If it is growing fast at 30% – 40% a year, the profit generated internally will not be enough. If it is from the share issuance, it will have a dilution effect. As long as the shares are traded at the current level, it is not very damaging, but a company usually has a hard time to find money when it needs it most. There is no assurance that the company can get the same valuation on its stocks when it needs the money to fund its future growth.
If it finances mainly by debt, it is certainly possible, as other auto companies already did it, but it puts the company into a greater risk.
In terms of working capital, it may be close to zero right now. (Although there appears to be about $1 billion working capital on the balance sheet, much of it may be just some reserve cash for the future capex.) I am not sure if this will continue though. If it has to rely on dealers later, it may need to increase the working capital.
2. Past fast growth in an overvalued market.
Yes, you didn’t hear me wrong. The past fast growth in the last 3 years could be a bad thing!
Of course, just by itself, the fast growth in the past is always a good thing. However, when the market is overvalued, a fast growing company with great awareness among small investors can get highly overvalued.
The only possible relief is the high short ratio. So it is possible that shorts are keeping the pressure on the share price. This force balances the potential over-optimistic valuation, and becomes a good thing instead.
Of course, it is unfair to say a company may be overvalued without giving a valuation first (I will give a valuation under various assumptions later), but at least it is a warning sign.
In fact, that optimism has already affected the CEO Elon Musk himself. As he mentioned recently, he thinks Tesla could pass Apple in market cap by 2025.
Even if we assume Tesla can continue to grow 50% a year for 11 years by the end of 2025, reaching a revenue more than double what GM has this year, for a 10% net profit margin, it requires a P/E of over 20 to pass Apple’s $700 billion market cap. At least for me, a P/E in that range for such a big company is pretty hard to imagine. Even Apple, with much better ROIC, a lot of cash, and a short term earnings boost could not reach that P/E in this overvalued market.
Now, growing 50% a year for 11 years is also going to be extremely difficult to achieve. It may be OK to grow 50% in 2014 or 2015, but this kind of exponential growth has to face a much bigger base later. If Tesla can’t deliver model X and 3rd generation EV on schedule, why would investors believe it will deliver 50% growth without any interruption for the next 11 years? Even if production can grow that fast, we don’t know if the demand will keep up the pace. Unlike solving an engineering problem, economic forecast is very hard to be accurate. There are simply too many moving parts in play to be fairly confident to bet on something in the next 11 years.
Since Musk got a lot of fans right now, a lot of admirers really trust his words. Given the so-believed potential of getting to the size of Apple without significant dilution, it could be particularly damaging if these people are willing to pay whatever the high price for the stock, and eventually get really disappointed by a reality check. I don’t think Musk had realized this, but he may have unintentionally reinforced the confirmatory bias of the shareholders.
Frankly, this kind of over-optimism can be very damaging based on what we have seen in the history, and even a great person like Musk would not be an exception.
Yes, I just mentioned that competitors are no match for Tesla. However, it is simply not right to ignore competition completely. After all, there are so many auto companies in this world, many of them are good copy-cats and some of them are fairly good at innovation too.
Of course, the success of any competitor doesn’t mean the failure of Tesla, since the potential EV market is huge. In fact, since the networking effect of charging stations is obvious, the success of other EVs may actually help Tesla at the early stage.
Still, it is important to keep competition in mind and remember that things may not be really smooth over the next 5 – 10 years.
Tesla is a for-profit company, but Elon Musk is not a for-profit leader.
It is kind of ironic to me that investors have worried so much about all those managers seeking profits for themselves at the investors’ expense, but now they have to worry about managers not so interested in profits at all.
This is certainly a “new” problem to investors, with not many precedents in history!
Although I am a big fan of Musk and fully admire his intention to help mankind, objectively as an investor, the non-profit-seeking nature could bring in a conflict of interests later. So far, we haven’t seen this as a big problem yet. The patents he gave up may not be that critical, plus it may bring in more goodwill and enthusiasm.
Just as an example, if Musk later finds that demand is not as strong as he expected, he might still choose to push on and invest in capex aggressively, simply because he is not concerned much about the risk. Also, since he said he would personally bet on getting to Apple’s market cap in 10 years, he may have more “commitment bias” and gets more aggressive on growth.
5. Key personnel risk
Elon Musk has showed his intention to leave the company once the 3rd generation car is ramped up to a certain point. Certainly, his contribution has been critical to the company. No other person will likely be an equal replacement.
6. The decline of oil price
Since shale oil has been growing fast and comes at a lower cost than the other non-conventional oil, and the demand has not been growing very fast recently, OPEC has decided to keep production volume without controlling the oil price any more.
While some people may think this is declaring war to US Shale Oil, we have to keep in mind that OPEC’s historical price manipulation was an anomaly in the commodities industry.
If their market share has not been enough to allow them to keep doing that, it will be a fundamental shift in the industry.
While $45 oil may not last long, it is also likely that oil price may just stay in the $60 – $70 range for the long term, which is just enough to keep Shale oil from growing too fast.
This certainly changes some of the economics of EVs. However, I don’t think this is a big problem in the next few years for Tesla, since I believe many more people bought Tesla because of its other innovations and features, rather than to save money on gas. (Those who just want to save money would not buy a much more expensive Model S.)
For the 3rd generation model, the low oil price may reduce the peak demand though. If the 3rd generation EV can save $1500 per year on gas price, this saving is going to be reduced by $400. This may translate to 10% higher cost for a $35,000 car. For regular folks who care about the features and the bills at the same time, it will reduce the eventual peak demand.
7. Short term challenges.
There are many short term challenges. Although they sound very serious, they don’t seem to be big problems in the big picture to me:
I. Strong USD.
The strong dollar has put pressure on all the export companies. It will do the same for Tesla. However, this is not a huge problem in the long term. In this race of currency devaluation, nobody knows what will happen later, and the force balances itself too (more trade imbalance will devalue US dollar).
II. Delay of Model X.
This should have been expected to happen. A delay of a project schedule happens a lot more often than delivering a project on time.
III. Demand from China was not as big as Musk expected.
This is not a long term problem either. It may take some time to get visibility and become another “fashion” product in China, but the ultimate demand is determined by the value of the product. Also, as mentioned above, since the two hurdles are “price” and “charging”, it is expected to get more early adoptors in a rich and small country. Places like HongKong seems to be the ideal target.
One thing that is common for the stock market is that the variation of the valuation is much more significant than the change of the fundamental.
Investors tend to buy/sell based on the mood of the day, rather than trying to quantify everything based on the facts.
So it is important to do a reality check by putting everything into numbers with reasonable and clearly documented assumptions.
Below you will find the basic assumptions of my valuation:
1. Tesla will not get serious challenges from its competitors.
2. Tesla will not have long term problems with demand.
3. Tesla will not have serious long term problems with scaling up the production. However, the speed of scaling up may vary.
4. Tesla may work on newer technology not related to EV, but this potential will not be included in the valuation, since it is hard to stay objective with fantasies or day dreams. It is also hard to quantify the potential in those areas.
5. Once reaching a certain scale, Tesla’s growth will slow down, so that we can use a constant P/E model to estimate its terminal value.
6. We assume the capital needs will be mainly financed by internal profits and external debts. We assume there will be 10 million shares dilution (about $2 billion capital in today’s price), and 4 million shares of stock options.
7. We will use a discount rate of 10% per year.
I certainly don’t claim these assumptions are right or safe, but any valuation has to be based on some assumptions. It is important to clearly document these assumptions and check whether the assumptions are still sensible from time to time.
1. Growth rate and years of growth.
This factor will have the most effect on value. We will try two growth rates: 30% or 40%, and years of constant growth at that rate for 7 years or 10 years. If the company grows 40% for 10 years, its sales will be $89 billion, which is 10% more than BMW’s sales.
2. Profit margin.
Considering that BMW has 20% gross margin and 7.5% profit margin, since Tesla has 26% gross margin right now, we assume the profit margin will be 10%.
Although better economies of scale may improve the margin, we also have to keep in mind that the 3rd generation models will be in higher volume and may have a lower gross margin than the luxury models. The EV credits may not last forever either (currently it is 4% of gross margin).
Also, since we assumed that it will rely mainly on debt financing for its capital needs, the high debt ratio will give higher risk, which also justifies a lower P/E ratio.
3. Terminal P/E multiple.
As I mentioned before, the variation on valuation is often the main source of capital gains/losses. Even if we assume the company has fairly stable earnings and growth, what P/E should we use for the valuation?
The long term return rate of an investment is usually somewhere between the current earnings yield and the ROIC, assuming the company doesn’t invest more capital than its earnings. Whether it is closer to the current earnings yield or ROIC, it depends on the potential market capacity, whether it can constantly win that market over its competitors, and how much it reinvests its earnings. Since we have assumed that Tesla will enter a slow growth phase after 7-10 years, a P/E of 15 makes sense given its large size, high debt ratio and slower long term growth.
Given the current sales of $3.1 billion, if we assume 40% growth for 10 years, 10% profit margin, a P/E of 15, 10% discount rate, 125 million shares outstanding and 12% shares dilution, the fair value is:
3.1 * 1.4^10 * 0.1 * 15 / (1.1 ^ 10) / (0.125 * 1.12) = $370 per share.
Here, we have all numbers in billions, and the formula is the following:
sales * (1+growth rate)^period * margin * PE / (1 + discount rate)^period / (number of shares * (1 + dilution)) = value per share
If we change it to be 30% growth for 10 years, it becomes:
3.1 * 1.3^10 * 0.1 * 15 / (1.1 ^ 10) / (0.125 * 1.12) = $177
Under the assumption of 40% growth for 7 years, it is:
3.1 * 1.4^7 * 0.1 * 15 / (1.1 ^ 7) / (0.125 * 1.12) = $180
Under the assumption of 30% growth for 7 years, it is:
3.1 * 1.3^7 * 0.1 * 15 / (1.1 ^ 7) / (0.125 * 1.12) = $107
Although the valuations I did above show more upside ($370) than the downside ($107), we have to keep in mind that the valuation is based on the optimistic basic assumptions, and those assumptions may simply be wrong.
The bulls may argue that Tesla deserves a higher terminal P/E after 7 or 10 years since it may maintain higher growth for a much longer time, and may even pass GM in sales. That is certainly possible, but it is more like a speculation than the current optimistic assumptions I have already made. For BMW, even in a bull market, it is still being traded at P/E 13 right now.
Clearly, the fair value for high growth stocks is a very wide range. This is mainly because of the difficulty of forecasting the potential growth rates for many years. In the past, not many people have been good forecasters, so it is always better to be on the cautious side.
So what does this article say? Is Tesla a good buy at the current price?
Investors tend to reach conclusions too fast. And value investors tend to assign a fair value to everything.
For high growth stocks like Tesla, the fair value is such a wide range that it is not easy to say what price gives a reasonable entry point. From all the points above, I believe a conservative entry point is around $130. That said, it may be OK to build a very small starting position at a price below $200.