The discounted cash-flow model behind TSLA stock is vulnerable should rates climb
The chances of an interest rate hike sometime in the next year have increased significantly. That change is very bad news for Tesla (NASDAQ:TSLA) stock.
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Just a month ago, the bond market was pricing in a 25.3% chance of at least one Federal Reserve rate hike by June 2022. In just one month, that percentage has climbed to 31%. Why? Last week, the Fed bumped up its time line for its next projected rate hike significantly. The Fed went from expecting no rate hikes until at least 2024 to projecting two hikes in 2023.
The timing and pace of Fed interest rate hikes most certainly hinges on whether or not the 3.4% inflation rate the Fed projects for 2021 is temporary. It’s unlikely the Fed will pull the trigger on an interest rate hike any time soon. But the sooner and the higher interest rates start rising, the worse it is for TSLA stock.
How Interest Rates Matter for TSLA Stock
Barron’s writer Al Root recently penned a concise explanation of why higher interest rates are worse news for growth stocks than the rest of the market. In a nutshell, growth companies generate a higher percentage of their cash flow years into the future. Higher interest rates mean future cash is worth less in today’s dollars in part because investors have an opportunity to earn higher returns from assets paying interest and dividends today.
As of March, analysts were projecting Tesla to generate $2 billion in cash flow in 2021 and $42 billion by 2030.
By utilizing the discounted cash flow valuation method, Root calculated that each 1% rise in interest rates today would hurt Tesla’s valuation by about $200 billion. Based on Tesla’s current $601 billion market cap, a 1% rise in interest rates would correlate to about 33% downside for Tesla’s stock.
“Tesla does not need to ever raise another funding round,” Musk said. “We may want to do so, but we are in a strong cash position, and we don’t need to.”
Since then, Tesla has completed 14 capital raises, raising a total of more than $22 billion.
Raising additional capital will be key to Tesla’s ability to grow, according to Bank of America analyst John Murphy:
“It remains to be seen if TSLA can capitalize on their first-mover advantage and stay dominant in the long term. Nevertheless, we continue to believe that as long as the company can fund outsized growth (new model introductions, capacity installation, etc.) with little to no cost of capital, as it has over the past decade plus, its high stock price will be justified.”
Cost of capital is a key concern, however. If Tesla continues to find investors to buy shares of stock, it can just continue to complete equity offerings. It’s easy enough to raise capital by diluting current shareholders. However, if it has to sell bonds to raise money, interest rates matter a lot. The interest paid on those bonds can get very costly if rates continue to rise.
Like Murphy, I gave up a long time ago on predicting where TSLA stock is headed next. In August 2020, Murphy upgraded TSLA stock from “underperform” to “neutral.” At the time, Murphy said Tesla’s skyrocketing stock price essentially allows it to raise unlimited cheap funding via equity offerings.
In other words, if there is no penalty for printing shares of stock out of thin air, Tesla and any other company can easily succeed.
TSLA Stock and AMC
Tesla a less extreme situation to what is currently happening with AMC Entertainment (NYSE:AMC). AMC’s business was on the brink of bankruptcy earlier this year. Then, its cult following of investors sent its share price soaring to “save AMC.”
AMC immediately started aggressively dumping shares into the market to raise the cash it needed to survive. The advantage of a cult following is that investors are willing to buy no matter how many shares the company sells. Even when AMC explicitly warned its shareholders they could lose “all or a substantial portion” of their investments, they didn’t care. These investors are essentially ATMs for companies like AMC and Tesla.
Rising interest rates are very bad for Tesla’s valuation based on a discounted cash-flow model. Will that matter to TSLA stock investors? Probably not. I continue to recommend not going long or short TSLA stock. There are plenty of stocks out there that still trade based on the value of their underlying businesses. There’s no reason for investors to rely simply on the irrational exuberance of other buyers.
On the date of publication, Wayne Duggan did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Wayne Duggan has been a U.S. News & World Report Investing contributor since 2016 and is a staff writer at Benzinga, where he has written more than 7,000 articles. Mr. Duggan is the author of the book “Beating Wall Street With Common Sense,” which focuses on investing psychology and practical strategies to outperform the stock market.
Article By Wayne Duggan, InvestorPlace