Tesla Inc (TSLA), Theranos: Why Runaway Stories Get Built

Professor Aswath Damodaran, a Professor of Finance at the Stern School of Business at New York University and a former contributor to Insider Monkey, recently took part in a Talks at Google session titled The Value of Stories in Business, detailing how to properly value stocks by having your own logical story that encompasses the justification for its various financial assumptions.

Prof. Damodaran touched on the concept of stocks that become runaway stories, stories that investors want to believe in so badly that they avoid asking questions that they might actually get the answers to; answers which could ruin the story, and analysts aren’t immune to that. He referenced blood-test startup Theranos as a runaway story that everyone loved, yet one in which few people seemed to be asking the most important question regarding the company: did its revolutionary, world-changing blood test actually work? Like, at all? As it turned out, it did not.

Prof. Damodaran stated that people might be surprised by the number of such stories that take off and keep going because people don’t want to ask the tough questions. He then turned his sights on Tesla Inc (NASDAQ:TSLA), on which he wrote a detailed analysis back in September 2013, in which he estimated the company’s value at just $67.12 per share when it was trading at over $168 per share (and now over $325).

Tesla Motors Inc (NASDAQ:TSLA), Logo on a Car, Sign, Brand, signage, electric car,

Hadrian / Shutterstock.com

In this case, he pointed out how analysts can become guilty of getting carried away with a story and not asking the tough questions that could damage that story. He referenced an analysis of Tesla Inc (NASDAQ:TSLA) done several years ago where the analyst predicted sales would rise to 1.137 million units by 2026 from 25,000 in 2013, with margins of about 7%.

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While Prof. Damodaran called those estimates at least plausible (if not likely), he noted that the analyst had completely failed to account for the fact that Tesla Inc (NASDAQ:TSLA)’s Freemont plant alone could not produce that many cars and that the costs of having to build additional plants had not been factored into the analysis and valuation at all. He called the analyst, who admitted that he had made a major gaffe, which came down to not asking the hard and/or right questions. Prof. Damodaran described such analysis as Oompa Loompa valuations, where you have all of this projected growth but haven’t accounted for the logistics of how that growth will actually be carried out.

Another interesting point raised by Prof. Damodaran was related to how important it is to maintain an open feedback loop. While he was specifically referencing analysts and their published valuations and how they shouldn’t blindly defend them, the point certainly applies to all investors. It’s important that we not only consider opinions contrary to our own, but even seek them out. This can be challenging not just in regards to investing, but in anything, where our ego tends to get the better of us, pushing us to stay within bubbles of positive reinforcement. Doing so shuts out a lot of opinions which may be perfectly valid save for the fact that we just don’t want to hear them.

In the case of Tesla Inc (NASDAQ:TSLA), which tends to be a highly controversial stock, it’s not hard to find contrary opinions, as many people are not buying into its runaway story. However, in the case of stocks that are mostly getting positive press, it behooves investors to seek out bear theories and whether those angles have any legitimacy, to ensure they aren’t getting swept away in unjustified hype along with all the other investors.

Tesla was owned by 38 of the hedge funds in our database at the end of 2016, up by four quarter-over-quarter. However, they owned just 3.50% of the company’s shares, as top money managers remain unconvinced by Tesla’s story. We are currently offering a 14-day money-back guarantee on our premium newsletters, which includes our small-cap hedge fund strategy, which has gained 43.8% since February 2016 vs. a 29.6% gain for the S&P 500 index ETF (SPY). Don’t miss out. You can check out the full Talks at Google session on The Value of Stories in Business below, it’s definitely worth a watch.

Disclosure: None