Several weeks ago Professor Aswath Damodaran of NYU posted a detailed valuation of Tesla Motors Inc (NASDAQ:TSLA) that I discussed with him and examined carefully.  In a previous post, I noted that Aswath made a host of highly optimistic assumptions regarding the future earnings performance of Tesla Motors Inc (NASDAQ:TSLA).  Despite the optimism, however, his value indicator fell short of $70 per share.  At the time, Tesla Motors Inc (NASDAQ:TSLA) was trading at $160.  Friday it closed above $190.  This leads to a very interesting question – who was buying Tesla at $190?  There are two basic possibilities.

Tesla and Apple

Tesla Motors’ Stock In Future

One is that there are those who see an extraordinarily bright future for Tesla Motors Inc (NASDAQ:TSLA).  And I do mean extraordinarily.  To justify a price of $190, it is necessary to assume astronomical growth rates in revenues over the next 10 years at continued high margins – in the highly competitive automobile industry.  It is hard to believe there are enough such optimists out there to maintain a price of $190.

The second possibility is that investors are willing buy the stock, even at prices that exceed what they see as fundamental value, because they believe that they will be able to sell it higher prices still in the relatively near future.  This is the basis for what is commonly called “momentum trading.” Although such trading appears to exist, economists still do not understand what causes it to arise and then collapse.  Some models suggest that what happens is that when prices stall, momentum traders attempt to take their profits.  But in trying to take profits, momentum traders end up attempting to sell into a market where there are no buyers because fundamental traders have already concluded the stock is overpriced.  The only buyers were momentum traders and now the momentum traders are trying to sell.  The result is a dramatic drop in prices to a level at which fundamental traders are willing to start buying the stock.

Of the two possibilities, the second seems to me to be a more accurate characterization of the trading in Tesla Motors Inc (NASDAQ:TSLA) stock though there is no way to know for sure.  If my conclusion is correct, at some point there will be a sudden, and likely quite dramatic, drop in the stock price reminiscent of the collapse in the price of Apple Inc. (NASDAQ:AAPL).

By: Brad Cornell, Professor of Finance at Caltech

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