Every now and then, you might encounter something in the stock market that makes you wonder: Am I crazy, or is everyone crazy? With what is going on at Tesla right now, I want to offer you the reassurance that it is the Tesla shareholder base that is completing disregarding the long-term intrinsic value of the corporation as the price of the stock has climbed from $35 last year to $585 now for a valuation of $555 billion.
The stock, which is set to be added to the S&P 500 in the coming days, is offering us a real-time lesson on why Jeremy Siegel’s papers concluded that investors would be better off owning the original S&P 500 without any of the additions that occur over time (the reasoning being that booted stocks usually are trading at too low of a price while the newly added stocks are getting there in part due to overvaluation).
Tesla is currently earning around $800 million in profit against $30 billion in revenues. The most ambitious analysts estimate that Tesla will be earning $70 billion in revenues in 2025. Even if we try to acknowledge the effect of Tesla’s reinvestment of earnings and instead assign it a hypothetical profit margin of 7% to approximate the historical average in the auto industry, that would still suggest that Tesla’s best case scenario is $5 billion in profits five years from now.
Typically, an auto company trades at 12x earnings. Even if we completely disregard that and assign Tesla a growth stock multiple of 30x earnings, the 2025 valuation would be $150 billion under a set of optimistic assumptions.
Given that the stock is currently valued at $555 billion, the stock should lose at least 72% of its value over the next five years. We have sort of been here before as the stock fell from $77 in 2017 to $35 in 2019 but the current overvaluation is so excessive that the next swing down is going to be far more painful for shareholders that hold onto it.
I can appreciate that sometimes a growth stock looks overvalued but then achieves blistering growth that can substantiate a high valuation and even create future wealth. I know darn well that Starbucks stock traded at over 50x earnings in the early 1990s and went on to deliver 23% annual returns to investors as it rolled out coffee shops that became ubiquitous across the world.
This is not that type of situation. This is a company with already $30 billion in revenues (i.e. decently mature) and trading at a current P/E ratio of 693. Even if it earned a hypothetical 7% net profit margin and were producing $2 billion in annual profits (which it is not), then the stock would be trading at a valuation of 277x earnings.
I did this with Beyond Meat, so I’ll do it with Tesla as well since the valuation is so out-of-control: A day will come sometime after November 29, 2030 when Tesla will trade at a lower price than it is does at the time of this writing ($585 per share on November 29, 2020).
Why do I feel that way? Based on any sense of conventional metrics, the stock would need to earn $29 per share in profits to justify its current valuation. It would need to be making $27 billion in profit, as opposed to the current figure of roughly $800 million, for investors just to break even over the ten-year time frame.
We always hear about the efficient/rational market and how people respond to events intelligently. That needs an important caveat, namely the word “mostly” and that when investors are taken in by momentum and a very entertaining story, gross overvaluation can still occur (see WeWork last year).
I have encountered investment commentary to the effect of, “Hey, I thought Tesla stock was overvalued, but then it went up from $87 to $585 so I guess I was wrong.” No! Don’t abandon rationality when faced with the present circumstance of a particular irrationality doubling, tripling, and in this case, quintupling down upon itself.
If you take nothing else from my writings, it is that you should think independently and follow facts in an if/then justifiable format to reach your conclusions. When you value a business, you have to use your own defensible metrics to arrive at a valuation rather than abandoning them when they instruct you to a conclusion that is different from the group.
Tesla’s stock price is trouble. The shareholders will lose a lot of their money, and the S&P 500 will be worse for including it at this time. You cannot pay a P/E ratio in the hundreds for a stock valued at half-a-trillion dollars. Reality always intercedes, fully though not immediately.