Bradford Cornell, professor of Finance, California Institute of Technology, was kind enough to send us, and give us permission to post the following academic paper which he just co-published with Aswath Damodaran, Professor of Finance, Stern School of Business, New York University. In light of the fact that many value investors believe that Tesla is a great company, but a poor investment, we thought readers would enjoy the following academic white paper.
Check it out Tesla Motors Inc (NASDAQ:TSLA): Anatomy of a Run-up Value Creation or Investor Sentiment?
Despite extensive literature on the subject, the question of whether and how market sentiment affects stock prices remains an interesting and unresolved question. Following DeLong, Shleifer, Summers and Waldman (1990), investor sentiment is here defined as a belief about future cash flows and investment risks that is not justified by the facts at hand. In this paper, we extend that literature by examining one particular event in detail. That event is an almost sevenfold increase in the price of Tesla in less than one year. On March 22, 2013 Tesla Motors Inc (NASDAQ:TSLA) was trading at $36.62. By February 26, 2014, the price had risen 590.9% to $253.00. (Tesla does not pay a dividend so the price path reflects the total return on the stock.) In comparison, the total return on the S&P 500 index during the same interval was a much more modest 20.4%, so that the total net of market return over the period for Tesla was 471.1%. An equal weighted index of the other major automotive manufacturers listed on American exchanges closely matched the overall market during the interval rising 16.2%, so Tesla’s jump clearly was not industry related.
Exhibit 1 plots the paths of wealth for Tesla Motors Inc (NASDAQ:TSLA), aforementioned index, and the S&P 500 (INDEXSP:.INX) from the date of Tesla’s IPO to the end of the run-up period. What makes Exhibit 1 particularly surprising is that for the first two and a half years following Tesla’s IPO in June of 2010, Tesla’s price tracks both the market and the industry indices. Then beginning on March 22, 2013, the two paths diverge dramatically. This paper studies that sudden shift and the subsequent dramatic run-up. In particular, we attempt to isolate the possible role played by market sentiment.
Of course, large increases in the price of individual stocks, though rare, are hardly unprecedented. However, Tesla Motors Inc (NASDAQ:TSLA) is special along a variety of dimensions that make it a uniquely useful test case for studying whether market sentiment played a role in the runup.
First, Tesla is part of large, mature and well defined industry. By 2012, the manufacturing of automobiles had matured to the point where the long-run growth rate of the industry closely mirrored long-run aggregate growth. This is helpful because much of the debate regarding the role of sentiment during the internet boom of the 1990s, and to an extent during the current social media boom, is over the extent to which sharp run-ups in prices can be attributed to rational assessment of industry growth. Because forecasting growth rates for newly developing industries like social media typically requires making assumptions that are hard to verify on the basis of historical data, unambiguous conclusions are difficult to draw.
Second, the mature state of the industry also makes it easy to identify comparable companies. This is helpful because comparable company analysis is a useful tool in valuation analysis. In addition, the slow, predictable growth of the aggregate market implies that a sudden, dramatic change in the value of Tesla stock means that Tesla must be expected to profit at the expense of competitors, so it is important to be able to identify those competitors unambiguously.
Third, the available technologies in the industry are largely known and innovations are incremental. There is not the “Twitter” problem where much of the value of a company is attributable to growth options related to some as of yet unspecified technology. Even Tesla Motors Inc (NASDAQ:TSLA), trumpeted as an innovator in the automotive industry, uses electric motor technology that has been widely available for years and relies on established battery technology and batteries provided by third party suppliers.
Fourth, the stable nature of the business implies that the expected return, whichever model is used to estimate it, should not be changing rapidly. Therefore, when investigating the sudden divergence of the stock price from movements in the market and the industry it is not necessary to waste time worrying about the changes being due to variation in the discount rate.
Fifth, the run-up in the price of Tesla Motors Inc (NASDAQ:TSLA) occurred over almost a year. Therefore, it cannot be related to the market learning of a few pieces of previously undisclosed information. It must reflect an on-going reassessment of the long-term prospects of the company, though not necessarily a rational one.
Finally, there is the added bonus that one of us, Damodaran (2013, 2014), developed a detailed discounted cash flow models for Tesla in real time and posted the results online on September 4, 2013 and March 25, 2014. As discussed in detail below, the models were calibrated using what we believe to be optimistic assumptions regarding Tesla’s future growth and operating margins. Nonetheless, the estimated values for Tesla were $72.00 in September 2013 and $100.31 in March 2014. In both cases this is only about 40 percent of the market price. If market prices continue to exceed model prices, or in the more extreme case that the gap widens, it is evidence that either our calibrating assumptions were too pessimistic or that the market prices are inconsistent with the DCF valuation.
We also employ standard analytical tools, including an event study and an examination of the holdings (including shorts) of Tesla stock, to supplement our valuation analysis. Here too we find evidence that the run-up cannot be attributed to a rational evaluation of fundamental news.
Tesla: A brief history
Tesla Motors Inc (NASDAQ:TSLA), incorporated on July 1, 2003, designs, develops, manufactures and sells electric vehicles and advanced electric vehicle powertrain components. The Company is also involved in designing, developing and manufacturing lithium-ion battery packs, electric motors, gearboxes and components both for its vehicles and for its original equipment manufacturer customers. Tesla owns its sales and service network. The company went public on June 29, 2010.
Tesla’s first car, the Tesla Roadster, a high-performance electric sports car, was a moderate success. On June 12, 2012, Tesla began deliveries of its Model S, a four door, five-passenger premium sedan. The reviews of the car were highly favorable and it was well received by customers.
Currently, Tesla manufacturers cars at its factory in Fremont, California. The company also has an electric powertrain manufacturing facility in Palo Alto, California.
In addition to building cars, the company provides services for the development of electric powertrain components and sells electric powertrain components to other automotive manufacturers.
Pricing versus Valuation: Convergence and Divergence
Though the words “price” and “value” are often used interchangeably, here they mean different things. For a cash flow generating asset or business, we define value to be the present value of a rational