How Insane Is Elon Musk’s $420 Valuation For Tesla?
This past week, Elon Musk tweeted that he was thinking of taking Tesla private at a price of $420 a share. That would be 18% more than $356, which is where Tesla’s stock closed last Friday. Is $420 an insane valuation? That depends.
On the one hand, if you bought Tesla at the end of last week, and Musk manages to take Tesla private within a year, you would have made 18 percent on your investment; in which case you would not conclude that $420 was insane. On the other hand, there are excellent reasons for concluding that $420 is well above Tesla’s intrinsic value.
Putting the last two points together implies the following: Any investor who buys or holds Tesla today is either a “greater fool,” or else is willing to risk a substantial loss in order to express their personal values. By “greater fool” I refer to the “greater fool” theory of asset pricing bubbles, whereby a foolish investor is willing to buy an overvalued security in the hopes that an even greater fool will buy it from him, before the bubble bursts. It is wise to remember that some greater fools get lucky and succeed.
A price of $420 sits in the upper end of the current Tesla target price range set by sell-side analysts, that being $195 to $500. Analysts’ consensus target price for Tesla is $326, which is not only less than $420, but is less than last Friday’s closing price.
Most sell-side analysts do not provide estimates of what they believe Tesla’s stock is intrinsically worth; but, a few do. J.P. Morgan is a case in point, and their target price for Tesla is $195, which is at the bottom of the target price range. Now, although the J.P. Morgan sell-side team set a target price of $195, it reports that the corresponding intrinsic value, based on a discounted cash flow computation, is a bit higher, at $216. This means that J.P. Morgan sell-side analysts are predicting that Tesla’s stock price will drop below intrinsic value within the next twelve months.
Here is a sobering thought. Any investor who makes the effort to work through the numbers that J.P. Morgan’s sell-side analysts have crunched will find that the $216 valuation is based on very optimistic assumptions.
Even though Tesla has had negative free cash flow for its entire existence, J.P. Morgan’s analysts assume that free cash flow will suddenly turn positive in 2019. They make the (implicit) assumption that after 2020, Tesla’s free cash flows will grow at a rate of 5.8% into perpetuity, a rate that is much higher than the estimated growth rate of the U.S. economy, or indeed the global economy. Finally, the J.P. Morgan team assumes that in the long-term Tesla will reinvest 29% of its net unlevered cash flows for growth. Yet, unless Tesla earns more than its cost of capital forever, the company could only achieve J.P. Morgan’s estimated free cash flow growth rate by reinvesting 40% of its net unlevered cash flows for growth.
When the market closed last week, Tesla’s stock was worth 79 percent of the combined value of the stock of General Motors and Ford; and it was worth more than each on an individual basis. Notably, Tesla’s sales have been less than 1 percent of the combined sales of General Motors and Ford! This fact further bolsters the argument that on an intrinsic value basis, it is not possible for Tesla’s stock to be worth even $216 a share, let alone $420 a share.
Tesla is now the most heavily shorted stock on the U.S. market. Just a couple of years ago, Elon Musk was more sanguine about Tesla’s high stock price, sometimes saying that it might be too high, and sometimes saying that if investors thought it was too high, they need not buy the stock. However, these days, Musk is at war with Tesla’s short sellers, and is waging that war on Twitter.
The behavioral asset pricing approach cautions that because of psychology, market price can move away from intrinsic value for long periods of time; and that the gap between the two can widen before it narrows. That is why investors who short overvalued stocks take on sentiment risk. If Tesla goes private at $420, short sellers risk not being able to come out ahead, even if the price of Tesla’s stock eventually falls to intrinsic value. The shorts will have to close out their positions before the gap closes.
Despite the short selling activity, investor enthusiasm for Tesla is strong enough to have sustained a significant price rally so far this month, and to have kept its price well above intrinsic value. Few of Tesla’s investors might have ever worked through the discounted cash flow analysis found in analysts’ reports. Instead, they are simply betting on Elon Musk, who history may well judge to have been brilliant. That Musk could accomplish what he has managed to accomplish in any one of financial transactions technology, electric cars, space travel, and solar energy is impressive. That he has done so in all four is nothing short of amazing.
For all his brilliance, it might well be that Musk does not know what Tesla is fundamentally worth. I have heard Tesla’s CFO say that Tesla does not try to figure out what the firm is intrinsically worth. Tesla’s financial managers instead focus on managing the firm’s financial strategy.
If Tesla’s financial management team took the trouble to compute the intrinsic value of their firm’s stock, they would be hard pressed to defend $420 as not being insane. Still, given investor psychology, and Musk’s track record, it would be insane to rule out Tesla going private at $420. Of course, greater fools will be needed for this to happen. Until the pool of greater fools dries up, price bubbles can continue to grow; but then they burst.