On September 8, the SP500 committee said “No” to Tesla (Nasdaq:TSLA) and published the 3 candidates to be included in the SP500: Etsy (Nasdaq:ETSY), Catalent (NYSE:CTLT) and Teradyne (Nasdaq:TER).

There was much speculation about the possible incorporation of Tesla to the famous stock index, but, contrary to the forecasts that many shareholders had made, finally Tesla was left out.

The market reaction, as expected, was quite negative, with a 21% drop in the session.

But what was the reason for the decision of the SP500 committee?

We will never really know, but there are indications that the real reason has been an exaggerated overvaluation in the stock market well above its intrinsic valuation.

For a company to enter the SP500, it must meet a series of requirements:

1- Market capitalization above $6 billions

2- Having presented profits in the last 4 quarters, or in the last quarter that compensates for the losses of the previous 3.

3- Have a minimum of 50% of stocks in public hands.

There has been speculation about what could have been the reason why the SP500 Committee did not include Tesla in the famous Index. Even in a recent SA article it was stated that the reason could have been not complying with the requirement of a minimum 50% of shares in public hands, but the author, after some subsequent inquiries, had to withdraw it due to some inconsistencies in his thesis.

In a recent article published in the Wall Street Journal: “Elon Musk’s Payday Could Cost Tesla Shareholders Dearly”, accounting discrepancies of the large incentives that Musk receives as compensation (about $1 Billion per year) were discussed as a possible reason. In this sense, it is stated that the SP500 Committee considers this accounting item as an expense for the period, therefore the results presented by the Company would be greatly affected. This is because they would have gone from being positive profits, to having to present high losses. And this last circumstance would make Tesla fail to comply with one of the main requirements to be included in the index: Positive profits in the last few quarters.

The same article establishes the possibility that the Committee modifies this requirement in the future to allow the inclusion of Tesla.

Personally, I think the justification has been, in addition to the inconsistency of the positive earnings presented by the Company due to various and dubious accounting practices (incentives for Musk, regulatory credits, etc.), an excessive overvaluation of the Company in the markets. That has caused Tesla to be priced excessively higher in Stock Market than its intrinsic valuation shows.

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As we will see later, the spectacular rise in Tesla’s price in recent months has caused the Company to operate with a very high P/E ratio. Its current market capitalization is not justified by its current earnings.

And the SP500 Committee does not like this situation, on the contrary, it likes to select Companies with valuations adjusted to their intrinsic value and that have presented consistently positive profits for several quarters.

On the other hand, and as I commented in my previous article about Tesla:

Tesla’s Next Second Quarter: Another profitable quarter is highly likely in the last few quarters, they’ve been dressing up the results with accounting tricks, like posting significant amounts of regulatory credits that have helped inflate earnings in recent quarters.

The SP500 Committee is not carried away by the large and exuberant expectations about Companies (Tesla), but prefers Companies with a consolidated positive evolution of the results over a period of several quarters or years, and with market valuations adjusted to their real earnings.

Therefore, I think it is difficult for Tesla to be included in the SP500 in the coming quarters, at least until it can adjust its market valuation to a reasonable P/E ratio, either because of an exponential increase in profits generated in the future, or by a reduction in its market value that makes the P/E ratio adjust to normal values.

SP500 Committee Likes Companies with Reasonable Market Valuations

The SP500 Committee likes companies with reasonable market valuations, and Tesla is not exactly a company that currently has a reasonable market valuation. This can be seen by comparing the P/E ratios of the latest companies that have been included in the SP500:

Companies adhering to the SP500 this September:

Etsy

Catalent

Teradyne

Q2 2020 P/E

77,4193548387097

58,9569160997732

19,1662673694298

Source: Author

Tesla P/E ratio:

Source: Author

Companies adhered to the SP500 last December 2019:

Live Nation Entertainment

Zebra Technologies

Steris

Q4 2019 P/E

110,169491525424

25,7352941176471

49,3421052631579

Source: Author

In the previous tables you can compare the P/E ratios of the companies included in the SP500 in September and the last December 2019. It can be clearly seen that the P/E ratios of the companies included in the SP500 present reasonable values ​​that range between 20 and 100, while Tesla stands at 858 !!.

But what about the big tech companies that belong to the SP500 and whose prices have increased enormously in recent years (Amazon, Microsoft, FB, Apple)?

Well, although they are companies whose stocks prices have experienced a huge revaluation in recent years, their market valuations are adjusted to the profits they generate. This can be seen in their P/E ratios:

P/E Ratio of Large Technology Companies:

Apple

Microsoft

Amazon

Facebook

Q2 2020 P/E

32,5862068965517

34,777895711479

114,567526555387

30,5684282130862

Source: Author

As can be seen, the ratios of the 4 large technology companies are around 30, except Amazon whose P/E ratio has shot up to 114. The case of Amazon is special due to the closure of recent months has shot up earnings expectations and therefore its share price have rise greatly.

Undoubtedly, the SP500 Committee avoids including Companies that present highly misaligned valuations with respect to their intrinsic value, as this can be a clear indication that the stock price may suffer significant fluctuations in the future. And a value with many fluctuations would negatively affect the stability of the SP500 Index, a situation that undoubtedly does not please the members of the Committee.

So will we ever see Tesla inside the SP500?

From all of the above it is clear that for Tesla to have real options to be included in the Index, and knowing that it meets the other conditions (capitalization greater than $6 billions, and shares in public hands in a % greater than 50%), or its stock price suffers a significant depreciation, or its profits should grow exponentially. These two circumstances would cause its market valuation to more closely match its intrinsic valuation and, therefore, its P/E ratio would drop to more reasonable levels. But starting from the current ratio of around 850, the variation that its stock price or its profits would have to experience (stock price drop or profit rise) would be enormous.

For example, for the ratio to fall from the current 850 to a minimum acceptable level of 100 (which is the current P/E Amazon ratio), the necessary variations would be:

P/E Ratio = Market Cap / Earnings

Current Tesla P/E = 850

Target P/E = 100

Options:

1) Tesla’s market capitalization would have to drop to $48.5 billions while maintaining the same current earnings:

P/E = $48.4 billions / $484 millions = 100

2) Maintaining current market cap, earnings would have to rise to $4.12 billions:

P/E = 412 billions $ / 4.12 billions $ = 100

As you can see, the variations necessary to lower the P/E ratio to 100, both in Market Capitalization and in profits are very high. Tesla’s annual earnings would have to be multiplied by 100!

Personally, I believe that both situations will occur in the coming months / years at the same time: earnings will grow progressively and market capitalization will stabilize or grow less than earnings.

But what is clear is that given the great magnitude that both would have to vary, it is not a matter of months, but of years. So, in my opinion, we won’t see Tesla in the SP500 for a few years.

Conclusion

There was a lot of expectation in early September about the possibility of Tesla being included in the SP500. But finally the decision was not to be included in the aforementioned Index. There has been speculation about the possible reasons that have led the Committee not to include the Electric Vehicle Company. Tesla really met all the requirements to enter: Capitalization greater than $6 billions, last quarters with positive profits, more than 50% of the shares in public hands. As I have explained in this article, in my opinion the real reason may have been the overvaluation that Tesla currently presents on the stock market. With a P/E ratio of 858, it is one of the most expensive companies on Wall Street. And this is not to the liking of the members of the SP500 Committee. Tesla would need to adjust its valuation in order to lower the P/E ratio to more reasonable levels, around 100. To achieve this, it would have to generate much higher profits than it currently has, or else its share price would drop significantly. In any case, that reduction in the P/E ratio that will surely end up happening, I don’t think it will happen before a few years.

So in my opinion, we won’t see Tesla in the SP500 for quite a while.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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