Since peaking at ~$883 on 1/26/21, Tesla stock (TSLA) has fallen by ~32% to $600. The pace of the decline has no double shocked many TSLA stockholders and casual observers. Some might even be tempted to buy the stock as these levels, thinking they are buying the stock 30% cheaper and hoping for a quick rebound to prior levels. I believe that would be a mistake.
Let me preface by saying that I think Tesla is a great company and they are the clear leader in electric vehicles (EVs). However, that does not change my opinion that the peak price of close to $900 per share was an inflated, unsustainable, bubble price that was far detached from reality to begin with. Let us not forget that TSLA was under $200 per share as recently as June of 2020 and just $70 per share in December 2019. If we take a step back, the better question is not why is TSLA down so much, but whether it should have ever been nearly $900 in the first place.
In the following sections, I first take a look at TSLA’s valuation from an industry perspective and then from a company specific perspective. Spoiler Alert: neither of these methods support TSLA’s valuation. But first, a quick look at why it is so tempting to believe TSLA will return to prior levels.
Anchoring is a well-studied cognitive bias in behavioral finance that describes the tendency for individuals to rely heavily on an initial piece of information to make subsequent judgements during decision making. This information can influence our judgments subconsciously even when it is completely irrelevant.
In one famous experiment, subjects were first asked to spin a wheel that was designed to land on either 10 or 65. The subjects were then asked to estimate the percent of African countries that were part of the United Nations. The subjects who saw the number 10 before answering the question estimated 25% on average. The subjects who saw the number 65 before estimated 45% on average. The subject’s answers were subconsciously influenced by a completely random wheel spin!
In stock markets, the anchoring bias can be equally powerful. Investors can anchor to a previously high stock price (such as the $800s for TSLA) and be slow to adjust when the price declines. Anchoring makes investors think there is a much higher probability of TSLA returning to $800-900 than there may be in reality.
Tesla Relative to the Auto Industry
On 2/20/21, when TSLA was ~$780 per share, Tesla was valued at more than $900 billion. It is hard for most people to grasp exactly how much $900 billion is so I found the following chart helpful. It shows that the combined market capitalizations of Toyota, Volkswagen, Daimler, General Motors, BMW, Honda, Stellantis (owns brands including Chrysler, Dodge, Ram, Fiat, Jeep, Opel, and Peugeot), Ford, SAIC Motor, Nissan, Renault, and Ferrari was only $800 billion! In other words, Tesla was valued $100 billion more than the entire combined traditional auto industry!
The insanity of such a high valuation is best revealed when you look at the following chart of Tesla’s sales as compared to those same companies.
Some might object that I do not understand the growth story. EVs are the future, and all those traditional internal combustion auto makers are dinosaurs destined to go extinct. Actually, I completely agree that EVs are the future. Let us explore this line of thinking further. If the market is valuing TSLA at $900 billion because it is Tesla’s destiny to replace the traditional automakers, one would expect the stocks of the traditional automakers to have fallen significantly (because they are the dinosaurs being replaced). The following chart shows the stock performance of General Motors and Ford. Instead of declining, the stocks have risen 60-70% over the past year as both General Motors and Ford have fully embraced the transition to EVs and publicly set targets for when they will go 100% electric.
It gets even crazier than that. Tesla is not the only electric vehicle company out there. In fact, there are dozens of start-ups, all sporting high valuations. BYD in China is valued greater than General Motors. NIO is valued higher than Ford. And until the recent stock market selloff, companies such as Li Auto and XPeng were also valued greater than Ford. Then there is Lucid, Nikola, Fisker, Lordstown, Rivian, Faraday Future, and the list goes on. Many of these also sport multi-billion dollar valuations.
So what you have is Tesla being valued more than all the traditional auto makers, the traditional auto makers being valued more than before because they are transitioning to EV, and numerous start-up EV companies being valued at the same level as General Motors and Ford. I think even the casual observer will see the math does not add up as all these valuations cannot be simultaneously correct.
For all of these valuations to be correct simultaneously, the EV auto industry will somehow have to be worth 3x the traditional internal combustion (IC) auto industry. Yet, we all intuitively know the total number of cars on the road will not change as EV cars simply replace IC cars one for one.
Actually, I believe the number of cars we need will decline significantly in the future as self-driving technology matures. Let us assume for a second that cars can drive themselves perfectly in 10 years. This would absolutely revolutionize car ownership and utilization. Prior to the pandemic, I had a 30-minute commute and drove to work at 7AM and left at 5 PM. For 95% of the day, my car would sit unused either in my home garage or at my work’s parking garage. If my car had full self-driving, it could leave after dropping me off in the morning and take another 2-3 people to work before 9 AM. After 9 AM, my car might do deliveries for Amazon. Around noon, it might deliver lunch for DoorDash. It would return to pick me up at 5 pm and continue with its night shift taking other people home. Instead of sitting idle for 95% of the day, my car might now be fully utilized for 50% of the day, all the while earning me rental income. Or perhaps I would not own a car in the first place, instead subscribing to an affordable Uber pass that takes me to and from work. Families may only need to own one car. The implication for the automobile industry as a whole is that we might need significantly fewer cars in the future when self-driving increases the productivity of previously idle cars.
I could see a future where we could have 30-50% fewer cars on the road. Does this reconcile with stocks being valued as if these new EV start ups will all turn into General Motors and Fords? And will General Motors and Ford also successfully transition to EVs? And can Tesla be worth more than everyone else added together? The bubble is not in just Tesla, but in all EV stocks.
The Software Story
Another common objection I hear is that Tesla’s value is not just about EVs, but really in the self-driving software they have. Let us assume Tesla’s car hardware division is worth about the same as the world’s most valuable automaker (which is Toyota at about $200 billion). To get to a $900 billion valuation, that implies Tesla’s software division is valued at $700 billion. I think it is premature to assign such a high valuation to a nascent industry where it is far from clear who the winners will be and what the ultimate profitability will look like. Tesla is not the only player developing autonomous vehicles. A partial list of companies working on self-driving technology includes Waymo (Google), Zoox (Amazon), Argo (Ford + VW), Cruise (GM), and Baidu among others.
Another interesting data point is that Tesla sells their self-driving technology (FSD) as an add on for Tesla car buyers. The following survey result from 3,000 Tesla owners shows that between Q1 to Q3 2020, only 25-40% of Tesla buyers actually paid for FSD. If 60-75% of Tesla buyers refuse to pay a few thousand dollars to enjoy FSD, should investors be willing to pay $700 billion?
Tesla Specific Valuation
Because Tesla has been unprofitable for most of its life and only recently started to make a small profit, the traditional price to earnings ratio is not meaningful (Tesla currently sports a cool 935 PE if you must know). When a company has little to no earnings, the price to sales ratio is a good fallback. Tesla currently trades for 14 times projected 2021 sales. This compares to the traditional auto makers at about 1 times sales.
Rather than compare Tesla to other automakers (which we have already done in the prior section), I prefer to compare Tesla to its historical trading multiple. The following chart illustrates Tesla’s historical price to sales ratio. As you can see below, prior to mid-2020, investors valued Tesla at between 2 to 5 times sales (still a healthy premium to traditional auto makers). At its peak, Tesla traded for 20 times projected sales!
What changed between the start of 2020 (pre-pandemic) and 2021? A bubble formed. Now that bubble may be unwinding. When this bubble fully bursts, I would expect Tesla to return to its pre-2020 valuation of 2-5 times sales. If that were to happen immediately, Tesla shares would be worth just $100-$300 per share.
Could Tesla grow into its valuation? To find out, I built a model for Tesla and assumed that Tesla unit deliveries grow 50% per year for the next five years through 2025. Tesla would be selling 4 million cars by 2025. I also assumed that the average selling price per car declines from $56,000 per car in 2020 to ~$40,000 per car in 2025. A decline in the average selling price should be expected as Tesla has announced its goal of producing a $25,000 car to address the affordability issue of current Tesla models. The net result is I have Tesla sales growing from $31 billion in 2020 to $160 billion by 2025. You cannot call me a Tesla bear with these assumptions.
Yet even with these assumptions and using a stock price of $600 per share, Tesla would still be trading at 5 times sales in 2025. Another way of thinking about this is even if Tesla delivers on this amazing growth, its fair value in 2025 might only be $600! Because the stock is currently about $600, it would be dead money for the next 5 years. Of course, stocks do not sit at a certain level for five years. The more likely scenario is Tesla stock eventually crashes to $200-300 before growing back to $600 in five years. That is a lot of stress and heartache with nothing to show for it.
This all still requires Tesla to successful grow sales to 4 million units by 2025. While there is a reasonable chance they could do it, it is also possible they could fall short. For a long time, there were no true EV competitors to Tesla. This is starting to change with many new competitors now entering the EV space. The recently released Ford Mustang Mach-E and the Hyundai Ioniq 5 have both gotten good press. In Europe, where EV competition is more intense, Tesla has consistently lost market share over the past year. Total tesla registrations in Europe actually declined 10% from 109,000 in 2019 to 98,000 in 2020. It is certain the competition will only get more intense. If Tesla falls short of my 2025 assumptions, the stock may not even be worth $600 in five years.
In summary, whether valued relative to its auto industry competitors or relative to its own historical valuation, Tesla’s former peak prices in the $800s seem insanely expensive. The stock is overvalued even at its current price of $600 per share. In the short term, the stock could rally from the heavy selling over the past few days, but in the long run it is valuations that matter.
I will end with one of my favorite quotes from Benjamin Graham (Warren Buffett’s teacher).
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”