A tasty week for Tesla
- China, EBITDA, Electric vehicle, Europe, EV, Forward multiple, Japan, Norway, Revenue, S&P500, Tesla, Trailing multiple, UK
- November 19, 2020
Tesla will be admitted to the S&P500 and will immediately jump into a top ten spot on the index based on a market capitalisation that appears to be marching towards $500bn.
The Index Committee was suspicious back in September when Tesla achieved profitability over four consecutive quarters, electing not to include Tesla in the index despite the criteria being met. Accompanied by a general sell-off of growth stocks at the start of September, that decision drove a nasty sell-off in the Tesla share price down to $330.
Elon Musk is having the last laugh though, as Tesla’s share price has topped $500.
What is the big deal about being included in the index?
So-called “tracker funds” (for example any S&P500 ETF product) will have to buy Tesla shares now to accurately track the S&P500 index. This provides strong share price support for Tesla. Similarly, when companies drop out of an index, tracker funds must sell the shares and things usually get a little ugly.
Perhaps more importantly though, it sends a message that Tesla has a sustainable profit trajectory.
What else is helping Tesla’s valuation?
A Biden-led administration will place renewed focus on climate change. Already, activists have a spring in their steps and governments are moving ahead with carbon emissions legislation in major first world countries.
Japan has announced a commitment to cut greenhouse gas emissions to net zero by 2050. China has committed to do so by 2060. Of course, these are nothing more than promises. China also made a lot of promises about Hong Kong and that’s not going so well.
The UK and various European nations have pledged to ban the sales of new internal combustion engine (ICE) vehicles in 2030. Naturally, there will be ICE cars on the road for years after that, as cars have a long lifecycle.
Norway has really gone to town with this, planning to phase out ICE cars from 2025.
Needless to say, this isn’t great news for oil giants. They must accelerate plans to move to renewable energy sources and biofuels. Emerging markets will be far slower on the uptake and simply don’t have the fiscal strength to incentivise EV purchases, so the ICE market will have a long tail in important emerging markets.
Tesla is currently the market leader in EV vehicles and clearly stands to benefit from this legislative focus, before we even consider the potential for its renewable energy business.
Have I changed my mind about Tesla?
Nope. I’ve never said that it isn’t a good company. I just struggle to get my head around people valuing Tesla as though it operates in a bubble devoid of competition.
We have more than a century of data on the automobile. At times, certain manufacturers have been ahead on engine technology while others have focused on style or branding. There are numerous manufacturers worldwide that have carved out niches for themselves and created millions of jobs directly and indirectly. Many people want to have a different car to the neighbours.
My point is that I don’t see how this level of infrastructure, customer knowledge and technological know-how is about to be swept away by Tesla or anyone else for that matter. Tesla has a great product by EV standards, but the world’s finest automobile manufacturers are just warming up to that space.
Tesla will grow quickly, there’s no question about it. Because it is coming off such a low base, the growth rate will look fantastic for a few years for both the EV market and Tesla. Whether or not the unit economics will improve (the profit per additional car) remains to be seen, but there should be benefits from manufacturing at scale.
The problem is that Tesla is trading at a revenue multiple of nearly 15x and an EV/EBITDA multiple of nearly 100x. The EBITDA multiple is a way of valuing a company based on the operating profit it generates (EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortisation).
Let’s look at some other market players and their multiples, with Tesla repeated in the below lists to demonstrate what an outlier it is.
- Tesla 14.76x
- Toyota 0.80x
- BMW 0.48x
- Volkswagen 0.43x
- Daimler 0.37x
- Ford 0.26x
- Tesla 99.40x
- Ford 15.52x
- Daimler 15.23x
- Volkswagen 6.43x
- BMW 1.95x
- Toyota 0.10x
(source: Yahoo Finance)
Trailing vs. forward multiples
These are trailing multiples. This means they are based on the last twelve months of revenue or EBITDA (as the case may be) vs. today’s share price. A forward multiple is based on a best estimate of the next twelve months of revenue or EBITDA vs. today’s share price. When a company “unwinds its multiple” it means that it grows into its boots.
There is also the concept of a growth ratio, where one can compare the multiples of different companies with different expected growth rates. A common example is the PEG ratio (Price / Earnings ratio divided by Growth). If a company has a P/E of 20x and will grow earnings 10% next year, the PEG ratio is 2. If the P/E is 50x and the growth rate is 25%, the PEG is also 2.
The same principle can be applied to EBITDA, although it isn’t commonly done.
For example, if Tesla grows EBITDA by 50%, then it is trading on an EBITDA growth multiple of around 2x (99.4x/50). If Volkswagen grows EBITDA by around 3%, it also sits on a EBITDA growth multiple of just over 2x (6.43x/3).
Assuming the market expects growth rates of 50% and 3% for Tesla and Volkswagen respectively, the valuation metrics of the companies are similar (both on a forward EBITDA of 2x). Investors will value a unit of growth in a particular industry and seek out a company that will provide that growth at a traded price that is below what the investor is willing to pay.
This is the convergence of growth and value investing, in line with how the likes of Warren Buffett have adapted to a new world of tech companies.
Forming a view on Tesla
One therefore cannot look at the trailing multiples in isolation and form a view. You have to consider the likely growth rate over the next 3 – 5 years and go from there.
Tesla is a classic growth stock, making huge promises about the future and being valued accordingly. Investors who get in on these shares before the growth spurt often do exceptionally well and deserve a good result. Those who climb in at the top sometimes get severely burned.
Whatever you do, don’t just invest in the hype. At least do some homework on the EV industry and Tesla’s major competitors.