Friday, February 13, 2015

Mr. Musk: Please Read Our Paper

              About six months ago, when Tesla was trading north for $250 per share, Aswath Damodaran and I published a paper arguing that a price of $250 per share was next to impossible to rationalize on a fundamental basis.  Even making optimistic assumptions, we arrived at a fundamental valuation on the order of $100 per share.  Since then, Tesla’s price has melted down to a less stratospheric $200.  Still high by our reckoning, but not ridiculous.  What is ridiculous is the recent statement by Mr. Musk that within 10 years Tesla’s valuation may approach Apple’s current $700 billion market capitalization.
              To see why, start with a simple calculation.  At $200 per share, the market capitalization of Tesla is $25 billion.  As a rough ballpark estimate, a fair risk adjusted rate of return on an investment in Tesla is about 10%.  Because Tesla does not pay a dividend, shareholders must earn all of this return in the form of stock price appreciation.  Assuming that Tesla appreciates at 10% per year for 10 years, the market capitalization will rise to $65 billion, less than 10% of Mr. Musk’s target of $700 billion.
              As a been stressed often on this blog, value creation on the order of that contemplated by Mr. Musk requires that a company earn returns far in excess of the cost of capital over extended periods of time.  That requires significant barriers to entry because every current and potential competitor will want to capture some of those excess returns.  In an industries as established as automobiles and batteries, it is hard to imagine that knowledgeable competitors, of which there are many, will sit back and allow Mr. Musk to earn extraordinary returns for decades at their expense.  If a new automotive design looks promising, they will adopt it.
              Of course, there is the example of Apple.  Apple’s market capitalization exceeds $700 billion because the company has been able to earn excess returns for more than a decade and the market expects it to continue for another decade.  But Apple is unique.  The company’s remarkable innovation, in conjunction with a strategy of coordinating software, hardware and design, has been brilliant.  Apple has also been benefited from a series of “butt fumbles” by its competitors that would make the New York Jets proud.  There is no evidence to date that Tesla is comparable to Apple in either respect.
              In short, for Tesla to be worth anything close to $700 billion in 10 years the company would have to move at “ludicrous speed.”  A potentiality that, from the point of view of any reasonable valuation model, is ludicrous.

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