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.
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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 forecast of future cash flows. Because “rational” is in the eye of the beholder, value cannot be observed and has to be estimated. When we use the term value in this paper, we mean our estimate of value. Price, on the other hand, is determined by supply and demand in the market place. That supply and demand may depend on factors other than rational estimates of future cash flow. Exhibit 2 lays out the contrast:
Rather than rehashing old debates about price and value, we use the evolution of Tesla as a case study of how both value and price evolve in the market. The analysis proceeds in three steps. First, we develop DCF models to estimate the value of Tesla under what we consider to be a set of aggressively optimistic assumptions. Next, we compare those estimates to the market price of the stock and find, as noted earlier, that the stock appears to be dramatically overpriced. In step three, we study the trading behavior of the stock both in terms of how it responded to information and in terms of changes in institutional holdings and short sales. We find further evidence consistent with that from the valuation analysis – the sharp run-up in Tesla stock far exceeds that which can be explained by fundamentals. Investor sentiment must at least be part of the story.
The DCF Valuation Models for Tesla
While the process for valuing mature businesses is well established and described, there remain substantial differences of opinion regarding how that process should be applied to young companies. The approach we use is that described by Damodaran (2013). This approach focuses on four basic inputs. The first input is the expected cash flow from existing assets. The second input is expected growth, with growth in operating income being the key input. Because this growth requires investment, the value effect of growth will depend upon how efficiently that growth is generated in terms of required investment. The third input is the discount rate, defined as the cost of the overall capital of the firm, when valuing the business, and as cost of equity, when valuing equity. Other things remaining equal, companies that operate in riskier businesses or riskier countries should have higher costs of equity and capital than companies in stable businesses and developed markets. The final input is the terminal value, defined as the estimated value of firm at the end of the forecast period. This estimate is generally based on the assumption that cash flows will grow at a constant rate forever beyond that point, which in turn, requires the firm to be mature and grow at a rate less than overall economic growth. In the case of Tesla this requires a long forecast horizon because a substantial period of supernormal growth is anticipated.
The challenge with young companies
Looking at the four inputs highlights the problems that analysts face in valuing young companies like Tesla Motors Inc (NASDAQ:TSLA). The cash flows from existing assets are often negative, with operating cash flows being non-existent or small (because the firm’s revenues are small) and investing cash flows being large (as the company ramps up for growth). As a result, almost all of the value of the company comes from future growth, but the crutches used to estimate that growth including past growth or sustainable growth models are missing.
In an earlier paper, Damodaran (2013) laid out a three-step process to deal with the estimation challenges raised by young companies. The first step is estimating a revenue growth rate. That estimate, in turn, is driven by an estimate of the growth of the overall market in which the company operates in conjunction with an evaluation of the relative strengths and weaknesses of the company’s products and services. The second step is forecasting a target operating margin to which the company’s margin will converge to over time. That forecast is typically based on the margins earned by the most comparable mature companies in the industry. The final input is an estimate of the investment required to achieve the forecast growth that is typically derived by examining changes in revenue from period to period and making judgments on how much additional capital will be required to provide for growth.
The discount rate in the valuation (cost of capital) is best estimated by looking at publicly traded companies in the same space as the young company, with the initial estimates being tied to smaller, riskier firms in the sector and the end numbers reflecting larger, more mature firms. While incorporating risk into discount rates is important, it is also important that we keep in mind two other factors. The first is that a significant portion of the risk that young firms are exposed to is company-specific and should be diversifiable at a portfolio level. The second is that young firms have a greater chance of failure than more mature firms, but that survival risk is ill suited for inclusion in the discount rate and is better considered explicitly when valuing the firm. This is because the cash flows to be discounted are expected cash flows, not anticipated cash flows conditional on the company surviving. To take account of this distinction, we introduce an estimated probability of failure, with the expected proceeds in the event of failure (usually liquidation proceeds) being used to compute an expected value.
Tesla’s Historical Performance
Though Tesla Motors Inc (NASDAQ:TSLA)’s history is short, the starting point for assessing future revenue growth is its past track record. Exhibit 3 plots quarterly revenues from inception through the end of 2013 for Tesla. The exhibit shows relatively flat revenue until the introduction of the Model S that led to a burst of growth that then flattens out.
Tesla Motors Inc (NASDAQ:TSLA)’s profits have followed a rockier path, with losses accumulating over time.
While the extent of the losses depends on the choice of measure, for much of Tesla’s history, every measure of profitability has been negative. In Exhibit 4, we graph six different measures of earnings:
(a) Gross Profits, i.e., revenues net of cost of goods sold.
(b) Earnings before interest, taxes, depreciation and amortization (EBITDA).
(c) Earnings before interest, taxes, depreciation, amortization and R&D (EBITDAR&D) to look at cash earnings prior to R&D expenses, which are more capital than operating expenditures.
(d) Adjusted EBITDA, obtained by adding back stock-based employee compensation expenses to EBITDA. This mirrors a number that Tesla has reported in it is financial statements over the last few quarters.
(e) Operating Income or EBIT.
(f) Net Income.
See full article in PDF format here: Tesla: Anatomy of a Run-up