Throughout this article, money amounts are expressed in billions of dollars.
Big valuation demands big performance
Tesla's share price has risen by 50% in just a few weeks, taking its capitalisation to 156. This is the market value of what the shareholders have at stake in the company. Add the exposure of the company's lenders, 5, and one finds a total enterprise value of 161 for the business.
This valuation is justified if Tesla has a fairly certain prospect of generating enough cash flow to return that 161, and rewarding stakeholders for the risks they are taking while they wait for that to happen. The two key questions are
how long do we give the company to bring that about? Pier Analysis uses a standard period of 15 years
what rate of return do we look for? Pier Analysis uses a standard rate of 10% pa.
Both assumptions are out of line with the market. Enthusiasts for Tesla argue that it is ahead of competitors in producing vehicles that can drive automatically, and that if it is successful in making this happen, it can capture a market that extends well beyond the manufacture of cars, and extends to owning a large part of the wider transportation industry: truck driving, van deliveries, taxis, the last of which, proponents argue, will replace ownership of cars by individuals. If this displacement is accomplished by Tesla, the company can be expected to endure for much longer than 15 years. Even so, for consistency with all its coverage of other companies, Pier is sticking with 15 years in this analysis. One of the distinctive features of Pier is that it makes its models available to subscribers, so if you want to explore time horizons longer than 15 year, you can do so.
The 10% rate is also controversial, but less so. Tech stocks are so fashionable that their valuations imply, and are driven by, low expectations as to yield. We though would look for at least 10% for a company that has yet to demonstrate that it can make a profit; we can get that rate from other investments at risks we consider quite low. Arguably, for a technology stock whose promise is all in the future, we might want quite a bit more. In this analysis, consistent with all our others, we will stick with a rate of 10%.
Necessary cash flow
Given these criteria, Tesla is attractive if we believe that it can generate cash flows of around 20-25. This is the violet line on the chart below.
More realistically, we could live with cash flows of much less than this level in the early years, if there was a reasonable promise that they would grow well beyond that level in later years. This is the red line on the chart. That needs to grow to about 35 in a few years time; as drawn, the red line is growing at 120% pa in the next five years.
We'd be equally happy with any of the lines between these extremes. Technically, what links all of these 15-year cash flows is that their net present value, when discounted at our favoured 10% pa discount rate, exactly matches the 161 enterprise value that Tesla has at the moment.
So what has Tesla actually managed in the recent past? That is what is shown on the black lines on the chart. The dotted lines are what the accounts actually show. The solid one is the result of some admittedly subjective adjustments, aimed at removing items that are unlikely to recur or can't be depended on, to see the underlying cash flow.
Actual cash flow
The black lines in the chart are taken from the analysis of cash flow that can be found in the model.
As we can see from the red ink in the bottom line of table, Tesla's cash flow was until recently negative. The price at which it could sell its cars was not enough to cover the cost of building them, let alone investing in new plant and equipment. Only in 2019 did it get to the point of earning enough to pay its way in cash terms. It is this breakthrough that has led to the surge in share price.
It still hasn't managed this feat in profit terms, but we have almost no interest in profit. Of rather more interest is that half of the 2019 enterprise cash flow of 0.7 came from working capital inflows, which are unlikely to continue forever.
Tesla doesn't just make cars. It has interests in battery manufacture and solar power generation. These activities would be worth looking at closely if the growth in cash generation needed to justify the valuation was more plausible. Given the valuation gap, there is no point in further inspection.
Could Tesla hit a medium-term cash flow target of 35? Of course it could. Anything is possible. But is it likely, or even plausible? Among tech companies, Apple's cash flow is around 50, and Microsoft is about 35, so it is not unheard of for companies to get to this scale. But there is nothing in recent cash flows to give confidence that this might happen. As things stand, Tesla is not an investment, but a speculation that the conjecture that it can capture a large slice of the world's transportation industry turns out to be true.
It’s the market, not the company
The technological changes that Tesla has brought to market, and the disruption it has wrought in its industry, have won it passionate admirers. Some devotees may find any scepticism objectionable. To them we say that what is here being doubted is not the good qualities of Tesla, which is a remarkable business, but the connection between the company and its valuation.
More than anything, the mission of Pier Analysis is to equip individuals with the tools to think about this connection, and the understanding that there is some price beyond which even the most magnificent company is too expensive to make a sensible investment.
That a company makes admirable products is not a reason to buy its shares at any price, and no discussion of a company's prospects is complete without this linkage.
What next?
A distinctive feature of Pier Review is that it provides the financial model that underpins each analysis. If you are content with a return less than 10%, or willing to wait more than 15 years for the return of your investment, you can impose less demanding requirements and see how the coloured lines on the projection of cash flow required to justify the valuation shift downwards. (The black lines on the chart will not move, since they are the result of Tesla’s reported historic performance.)
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