While some see Tesla (TSLA) as the savior of the EV market and the electrical storage market, others see Tesla as a hopelessly overvalued company that will probably never make it to sustainable profitability. Who knows, it is quite possible that in 10 or 20 years, we will say that 2020 was a pivotal year for Tesla. Several interesting things have happened this year that show investors how crazy and paradoxical the stock market can be. In my opinion, the year also indicates that a business worth investing in is not always a good investment.
The paradox: Overvaluation ensures that Tesla becomes investable
Tesla was not profitable for many years. That is nothing new. The only crazy thing was that despite the lack of profitability, the company had a higher market capitalization than its established competitors.
But at the heart of the matter, Tesla always burned cash. In 2017, for example, Tesla made a loss of USD 2.37 per share and burned USD 5 per share. Such a company has only two options. It can increase its foreign capital or its equity capital. Both are rather disadvantageous for investors. Increasing equity by issuing new shares reduces the profit of existing investors. Borrowed money grows debt and limits financial leeway.
At Tesla, two enormously favorable developments came together. On the one hand, the interest rates are extremely favorable. This allows the company to take on new debts, for example, to pay off old debts.
But much more important was what Tesla did at the beginning of the year when the share price exploded. Elon Musk had excluded capital increases for a long time. In February 2020, however, Tesla announced that it wanted to raise USD 2 billion by issuing new shares. It was impressive that Elon Musk wanted to buy USD 10 million of common stock. In the end, however, this was only a small part, and there are many indications that Elon Musk also saw an enormous overvaluation in the share price.
However, the action came when Tesla was about to position itself as a profitable company. The move enabled Elon Musk to reduce the debt ratio to the low 60 percent figures. For a company that has been in deficit for years, this is quite a remarkable figure. Tesla now even has a positive cash flow with which it can address debts and liabilities.
Debt to total assets and amortization power, source: www.DividendStocks.Cash
Below is an overview of the increase in new shares issued. As you can see, over the years, there has been a considerable dilution of the shareholder equity value. With the issue of new shares at the beginning of the year, this dilution has accelerated even further.
But if we consider this dilution effect as a side note, we can at least state the following.
- Tesla has made a profit for the fifth consecutive quarter. Compared to the 3rd quarter of 2019, the profit has even doubled. While for companies like Volkswagen (OTCPK:VWAGY), BMW (OTCPK:BMWYY), Daimler (OTCPK:DDAIF) (OTCPK:DMLRY), Ford (F), General Motors (GM), such a report is no real reason to freak out, for Tesla as a young company it is quite a respectable achievement.
- The balance sheet now also looks solid. Volkswagen and Daimler, for example, have a much higher debt ratio than Tesla. Since Tesla is profitable, enormous investment risk is minimized.
Tesla’s business is, therefore, profitable and has a financially sound foundation. For me, these are the key figures of a company worth investing in. Yet, it is a paradox that it was precisely the years of overvaluation in relation to competitors that helped Tesla save itself into the profitable phase. If interest rates had been higher and the market had punished Tesla more for the cash drain and lack of profitability, this story would probably not have been possible.
What makes an investment-worthy business a good investment
Tesla has achieved something that in itself is not worth mentioning, but in the case of Tesla, it creates respect. The production of cars is a very low-margin business and characterized by intense competition. Tesla has managed to make this business profitable and still invests in further growth, such as in the new gigafactory 4 in Germany.
Nevertheless, this says nothing about whether you should buy Tesla shares. It is like with Tesla cars. Customers are only willing to pay a specific price for the vehicles. The main reason for this is opportunity costs. Why buy a Tesla car when you could afford three other vehicles from other manufacturers and a holiday trip to Seychelles (an exaggerated but clear picture).
On the other hand, perhaps it is just that no other company has such good prospects of success in the EV market as Tesla. Even if the big established manufacturers are putting pressure on Tesla, Tesla is the market leader today. So why invest in other companies that are not as good as Tesla? This is also a consideration that falls under the label opportunity cost. To put it in the words of Charlie Munger:
I would argue that one filter that’s useful in investing is the simple idea of opportunity cost. If you have one opportunity that you already have available in large quantity and you like it better than 98 of the other things you see, well, you can just screen out the other 98 percent because you already know something better.
However, even if we assume that Tesla is the only company worth investing in, would it still be a good investment? It depends on your perspective. Do you look at the price, or do you look at the value behind the share? There are good reasons that the price continues to rise now that Tesla is growing profitably. Conversely, growth is not always a guarantee for increasing prices. If you speculate on rising prices, you speculate that someone is willing to pay more than you have paid for the same share in the company. Of course, you know the phrase “Price is what you pay, value is what you get.” It may well be that the price increases in parallel with the intrinsic value. At Tesla, it is quite interesting to note that EPS, for example, has increased by 864 percent in the last five years, but the price has risen by 1500 percent. Revenues have increased by only 600 percent. The price is, therefore, far ahead of the operating performance. So now you are paying for something that you will only get in a few years.
This also becomes clear when we look at historical multiples. But we have to be doubly careful here because the multiples are incredibly distorted. Tesla only makes a profit for a few quarters, which is why the fair value here is already very high.
Fair value calculation Tesla, source: www.DividendStocks.Cash
Accordingly, we should readjust here. And indeed, a different picture quickly emerges when we use other fair value multiples. For example, if we take an adjusted P/E ratio of 50, then the expected profit at the end of 2023 has a downward potential of more than 50 percent. Even an adjusted P/E ratio of 100 would still indicate a downside risk of 5 percent at the end of 2023. So if you buy shares now, you will have to wait another 100 years in 2023 for the profit to equalize your initial investment, which does not sound like a good investment to me.
Of course, this is an unsafe calculation, as Tesla may well double or triple its profits in the next few years. Nevertheless, it is not unlikely that this hope is already priced in. And the reality is also, that car manufacturers usually have a single-digit P/E ratio. If bulls now say Tesla is not a car manufacturer, but a tech company, then these are the same arguments as years ago, and yet Tesla makes the bulk of its revenues with its cars, as does Volkswagen, or Daimler, etc., all of which also invest in other areas (e.g. air cabs, how tech is that?). So I do not think, that I can give much weight to this argument because this is valid for other manufacturers too.
A company that is worthy of investment is not automatically a good investment. I do not invest just because I believe that the price of a share will rise or not. The Tesla stock is not giving me enough at the moment to want to invest in the company. Maybe I will miss further price gains. That’s okay with me. Investing is not a race. It is wealth management, and with wealth management, there is only one rule: don’t lose money.
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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.