Thesis
Tesla (NASDAQ:TSLA) is a unique stock because it is the best option for exposure to the fast growing EV industry, and because it has become large enough that it can have an outsized impact on index returns going forward. The current valuation could be justified based on EV sales alone, but it requires moderately optimistic assumptions about market share and profitability. The other business lines (namely full self driving and robotics) have potential, but I have concerns about them that prevent me from considering them in the valuation at this point. Tesla is probably overvalued based on analyst estimates, but undervalued based on the company’s own projections. Thus, risk tolerant investors who aim to outperform the index can continue to hold Tesla or open a small position in it.
Introduction
Tesla has become an impossible company to ignore. As the S&P 500’s (NYSEARCA:SPY) 6th largest company with nearly $1T in market cap, even investors who simply buy index funds now have significant exposure to it. Investors whose goal is to outperform the index have to consider the potential for Tesla to have significant impact on the index’s returns going forward.
While I initially wrote Tesla off as a meme stock or bubble and was concerned about Elon Musk’s eccentricity, the more that I research the company, the more that the current valuation looks potentially justifiable. I’ll aim to explain why in this article.
The EV Business
Tesla’s primary business is selling electric vehicles. This business has seen rapid growth, with Tesla growing revenues at an incredible 70% CAGR since 2009. Tesla currently has 66% share of the USA EV market but only 15% share globally. This share has been declining but the overall market is growing very quickly.
Going forward, Tesla aims to sell 20 million cars per year by 2030, representing a 40% CAGR this decade. This is a very high growth rate – especially for a non-software company – but it’s slower than Tesla’s growth last decade. Analysts still don’t believe it, with Seeking Alpha showing an analyst consensus of 20% revenue CAGR for Tesla this decade.
The critical thing to understand about the future growth of EVs is that it won’t just be driven by idealistic environmentalists buying them to save the planet. The cost of EVs has declined rapidly, as they have become an average of 18% cheaper in each of the last four years. This rate of cost decline is expected to continue, ultimately making EVs at least 25% cheaper than ICE vehicles and creating massive demand. This demand would hold up even in a less favorable regulatory environment.
Although there’s always risk that the rate of cost decline will slow or that Tesla won’t execute to meet demand, it does seem most likely that EVs will eventually be cheaper than ICE vehicles. The legacy auto industry also seems to have taken this view and is now scrambling to manage the EV transition. A survey shows that the average auto exec expects over 50% of new car sales will be electric in 2030, although the responses varied widely from 20% to 90% (up from 9.1% in 2021 and just 1.9% in 2019).
Tesla has a very favorable position in this growing industry because they are considered the first mover and current leader in EVs, giving them significant brand value. Tesla has the most market share for EVs and will likely continue to be the sales leader going forward. These factors could be considered a moat source based on intangible assets and efficient scale.
FSD & Other Businesses
Tesla has a lot going on. Aside from selling cars, the company offers or is developing:
- Energy storage products
- Solar panels
- Insurance
- Super charger “gas” stations
- Autonomous driving (FSD) tech
- Software subscriptions
- Robots
- Bitcoin (on their balance sheet)
It can also be argued that the whole is more than the sum of its parts. For example, Tesla should be able to offer better rates for car insurance because it can collect data about how safely its customers drive. It can also use this data to improve its AI for FSD software.
However, at present Tesla is mostly in the business of selling cars. All of these other areas made up only 17% of Tesla’s revenue in 2020 and most of them will not grow as quickly as the core EV business.
According to Tesla, the exception to this is FSD. Tesla currently offers an autopilot mode where the car will drive itself but a driver still has to be behind the wheel. The company’s long-term goal is to get regulatory approvals for FSD and roll this mode out as a software update to their vehicles that are already on the road. Then they will release an app similar to Uber, which would allow users to get a ride from a FSD Tesla that someone in their area owns. Tesla and the vehicle owner would share the high margin revenue, and the ride would be cheaper for the passenger than a human-driven ride by Uber. In the medium term, Tesla could launch the app with a driver behind the wheel, but the eventual goal is to remove the driver completely.
In theory, no company is better positioned than Tesla to make a service like this since they already have a fleet of cars around the world they can use. Assuming, that is, that Tesla owners are willing to use them as taxis and that Tesla is able to make FSD work on their existing vehicles.
It’s the latter point where I become more skeptical, especially since the company has a history of overpromising and underdelivering in this area. They predicted this taxi service would launch with human drivers in 2020, but it’s yet to see the light of day. This short video shows Elon Musk promising various levels of autonomy every year since 2014, and generally being too optimistic about his predictions.
Although the autopilot mode that Tesla recently rolled out helps get test miles, it’s still concerning to me that Tesla isn’t on this fairly long list of companies approved for driverless test permits in California. Tesla’s approach is radically different from the approved companies’, as among other things they are the only company on the list that doesn’t use LIDAR hardware to understand the vehicle’s surroundings. If, for example, it turns out that only cars with LIDAR can get regulatory approvals for FSD, then Tesla couldn’t roll out the change as a software update to existing cars, which would negate their aforementioned advantages.
Many analysts like to speculate about whether Tesla or Waymo (NASDAQ:GOOG) has a better approach to FSD. In my view, there are very smart people working at both companies and if it was clear at this point that one approach was superior, we’d already be seeing the other company doing a massive pivot. It’s safe to say that nobody really knows what will happen, and that FSD is a very difficult problem to solve from both a technical and regulatory perspective. For better or for worse, Tesla’s approach seems the most unique among the FSD companies.
Since Tesla has no FSD revenue at this point and I have doubts about their approach to the space, I believe that it’s still too early to factor FSD into their valuation. I don’t think it’s guaranteed that FSD will be universally solved from a technical perspective this decade – by Tesla or anyone else – and even if it is, I don’t think that everyone will be eager to use it right away. ARK estimates that robotaxis represent a $2 trillion profit opportunity (meaning that FSD rolled out today would represent 29% of GDP). So it’s safe to say that waiting to invest until Tesla’s robotaxis actually hit the road wouldn’t mean missing the boat.
I’d make the same argument about the recently unveiled robotics initiatives, since Elon Musk believes that the robot business could eclipse the car business eventually, but they don’t have any sales yet.
However, in the next section, I will show that Tesla may only need the EV sales business to do well to justify its current valuation.
Valuation
The two most important questions to answer regarding Tesla’s valuation are what a fair terminal multiple is for the company and how much it will grow before reaching that point.
Tesla has historically traded at a rich valuation and managed to live up to it. As long as the company continues growing, I expect it to trade at an elevated P/E. I will use a terminal P/E of 25 in 2030, with the assumption being that Tesla will continue growing earnings at a 15-20% rate even after that point, leading to a reasonable PEG ratio. Those who make different assumptions can adjust their model to use a different terminal multiple.
Interestingly, Tesla already has a forward P/E of 25 in 2030 when using analysts’ growth estimates according to Seeking Alpha. This is quite high compared to the FAAMG stocks, but it still means that Tesla would have a positive return if it beats analyst expectations and retains this multiple.
Based on analyst consensus, Tesla will have a forward P/E below 50 in just a few years. If the stock traded flat or declined during that time, I think that even GAARP investors could then seriously consider Tesla at 50 P/E with 30%+ growth versus say Apple (NASDAQ:AAPL) at 25-30 P/E with 10-15% growth.
If instead of using analyst estimates we take the company at face value and say that their goal of 20 million cars sold in 2030 will be achieved, this represents a 40% CAGR in deliveries and likely significant upside in the stock price. This growth depends on cost reduction, so it should translate to revenue growth of about 33% if sticker prices keep declining at 17% per year. That leads to $700B in revenue in 2030. This is conservative since it’s more likely that cost declines will eventually plateau rather than decreasing 80% from current prices in 9 years. More likely we’d see a 40-50% total decrease.
Morningstar models that Tesla’s gross margins will expand from 29% to 39% by 2030, which combined with modestly improved operating leverage could put Tesla’s profit margin at around 20%. $140B earnings at a P/E of 25 would give Tesla a $3.5T valuation (it’s worth slightly less than $1T today).
So, if we take Tesla’s growth estimates as accurate and make relatively conservative assumptions about pricing and margins, Tesla would easily be a market-beating investment, returning around 250% this decade based on EV sales alone. Its days of returning 10x might be over, unless its FSD/robotics initiatives pan out. But most investors won’t complain about 250% returns either.
On the other hand, if analysts are too bullish and Tesla or EVs in general don’t become as popular as expected, the stock could easily lose most of its value. For some perspective, using Tesla’s estimates it would have about 27% of the overall auto market share in 2030, and using analyst estimates it would have 13% share. Right now the most dominant auto maker is Toyota (NYSE:TM) with just 8.5% share. So both analysts and Tesla have optimistic assumptions about Tesla’s future market share, and believe that they will gain share of the overall auto market as EVs take share from ICE.
It hasn’t always been the case that the auto industry was so fragmented, internationalized, and debt-ridden. For example, in 1990 the two companies in the S&P 500 with the most revenue were Ford (NYSE:F) and General Motors (NYSE:GM), and they were also top 3 in profits. A lot has changed since then, but there’s clearly precedent for auto makers being some of the largest companies in the world.
Conclusion
Tesla becoming a dominant player in EVs and EVs overtaking ICE vehicles seems like the most likely outcome. Even so, and even considering that analyst estimates are typically easy to beat, if the massive projected growth of the EV market doesn’t pan out, then investors could lose a large part of their investment in Tesla at these prices. On the other hand, developments in robotaxis and other types of robotics could give Tesla substantially more upside than it has with just the EV business, and Tesla has a path to further upside with just the EV business. There are a wide range of potential outcomes, which makes Tesla a very high uncertainty stock.
Normally, I would avoid a stock with this much uncertainty. However, Tesla’s large weighting in the S&P 500 – an index that I aim to beat – has made it difficult to ignore, especially since there aren’t many alternate investment opportunities in the EV/FSD/robotics area. Investors who avoided investing in FAAMG last decade due to valuation concerns and uncertainty probably had a difficult time beating the index. Right now, Tesla looks like the only non-FAAMG company with enough growth and size (besides maybe NVIDIA (NASDAQ:NVDA)) to have a similar effect this decade. As such, risk tolerant investors who aim to beat the index should consider holding Tesla, especially from a low cost basis. Those who don’t own Tesla yet could potentially open a position on this pullback, with the goal being to take a delta neutral position on Tesla relative to the index. I opened a small position myself over the last couple days.
Some people will call this line of reasoning fear of missing out, but I consider it closer to speculation. After my research, I’ve come to understand that Tesla’s current valuation isn’t just based on FSD pipe dreams, but rather on ambitious but potentially attainable EV sales growth. That is, I see a path to further upside in an industry that I’m not otherwise exposed to. I wouldn’t buy the stock if I didn’t believe further upside from fundamentals was possible, regardless of its index weight.
Even if this growth doesn’t come to fruition, as a long-term investor, I’m much more comfortable losing 1-2% of my portfolio invested in Tesla than I am with missing out on potentially 10% or more of the market’s return this decade because I was too focused on Tesla’s downside risk to see its potential for further upside.
I’ll leave investors with this quote from Elon Musk:
Leave a commentI believe everything I’ve ever said would come true, did come true. It may come through late, but it did come true. Punctuality is not my strong suit, but I always come through in the end.