Dear Valued Visitor,

We have noticed that you are using an ad blocker software.

Although advertisements on the web pages may degrade your experience, our business certainly depends on them and we can only keep providing you high-quality research based articles as long as we can display ads on our pages.

To view this article, you can disable your ad blocker and refresh this page or simply login.

We only allow registered users to use ad blockers. You can sign up for free by clicking here or you can login if you are already a member.

Valuation of the Week 1: A Tesla Motors Inc (TSLA) Test

Based on my estimates, Tesla will generate more than $8 billion in operating income by year 10, making it more profitable than all but three other automobile companies today (Toyota, Volkswagen and BMW).

Investment Requirements 

Growing revenues roughly sixty fold and improving operating margins to match the most profitable companies in the sector will require reinvestment. Some of it will take the form of additional R&D, as Tesla tries to keep its competitors at bay, and some of it will have to be in more conventional assembly lines and factories, as production gets ramped up. Over time, I believe that the latter component will come to dominate the former.

In my forecasts, I have assumed that Tesla will have to invest about a dollar in capital (in either R&D or plant/equipment) for every additional $1.41 in revenues. That matches the industry average of the sales to capital ratio of 1.41 for US companies. Since the sales to capital ratio for technology companies is higher (2.66), it is possible that I am over estimating Tesla’s reinvestment in the early years. However, the return on invested capital that I obtain for Tesla in steady state (in year 10), based on my estimates of operating income and invested capital, is 11.27%, putting it again at the top decile of automobile companies.
Risk

Tesla is undoubtedly a risky investment and there are three components of risk that I attempted to incorporate in the valuation:

a. Business/ Operating risk: Tesla Motors Inc (NASDAQ:TSLA) is exposed to substantial business risk, some coming from macro economic sources (the strength of the economy, inflation, interest rates), some resulting from technological shifts (the winning technology in the electric/hybrid auto business is still to be determined) and still more emanating from the sector (with every major automobile company staking out its claim on this segment of the business). To capture the risk, I assumed that Tesla, as it stands now, exposes investors to a mix of automobile business risk and technology business risk. While I assumed a 60% auto/40% technology mix in arriving at a cost of capital of 10.03%, the value per share that I obtain is not very sensitive to this assumption:

Treating Tesla as a purely automobile company increases its value to about $74.73, whereas treating it as a technology company lowers the value per share to $60.84.

b. Geographic risk: While it is likely that as Tesla grows, it will have to look to emerging and more risky markets, I will assume that its risk exposure for the next decade will come primarily from mature markets, allowing me to use my current estimate of the equity risk premium for the US of 5.8% for the cost of equity/capital computations.

c. Truncation risk: Tesla Motors Inc (NASDAQ:TSLA), in spite of its lofty market capitalization and recent successes, is still a young, money-losing company. A large shock to its business (from a legal setback, a recession or a sector-wide slowdown) could put the company’s survival at risk. While that risk has declined substantially over the last two or three years, I think that it still exists and will attach a probability of 10% to its occurrence. If the company does fail, I will also assume that it will lose a significant portion of its value in a distress sale (receiving only 50% of estimated value).

DOWNLOAD FREE REPORT: Warren Buffett's Best Stock Picks

Let Warren Buffett, George Soros, Steve Cohen, and Daniel Loeb WORK FOR YOU.

If you want to beat the low cost index funds by 19 percentage points per year, look no further than our monthly newsletter.In this free report you can find an in-depth analysis of the performance of Warren Buffett's entire historical stock picks. We uncovered Warren Buffett's Best Stock Picks and a way to for Buffett to improve his returns by more than 4 percentage points per year.

Bonus Biotech Stock Pick: You can also find a detailed bonus biotech stock pick that we expect to return more than 50% within 12 months.
Subscribe me to Insider Monkey's Free Daily Newsletter
This is a FREE report from Insider Monkey. Credit Card is NOT required.