This article was published more than 2 years ago. Some information in it may no longer be current.
There's no doubt about it – the promise of electric vehicles is exciting investors. Eight years ago their market share was near zero. After growing annual sales by over 50 per cent a year, electric vehicles now command over 1 per cent of new car sales globally and a far higher share in some European countries. And as sales have shot up, costs have come down. In 2009, battery costs ran to over US$900 per kilowatt-hour; today, costs for leading manufacturers are below US$250/kWh. Forecasters from investment firms to national parliaments see further growth ahead and many view an all-electric road as inevitable.
There are many companies with favourable exposure to electric vehicles, from cobalt miners to battery manufacturers to specialists in electrical systems. But only Tesla has Elon Musk. It seems natural that a man who can send a car into orbit and sell US$3.5-million of flamethrowers in a day can achieve anything, including dominance in the auto market. He tells a compelling story, arguing that "Tesla has real potential to be one of the most valuable companies in the world," and investors seem to be buying it. In the years since its 2010 IPO, the company has tapped equity and debt markets for over US$13-billion, and it has been a rewarding ride for early investors – today the company's stock is worth over US$50-billion.
There is no doubt that Tesla's growth prospects are exciting. Over the past five years, it has grown its revenues fivefold while some other auto makers have struggled to grow at all. But at current share prices, this promise may already be fully appreciated by the market. High expectations are easier to miss and often lead to disappointment. So what expectations are reflected in Tesla's valuation? To assess this, let's compare Tesla's market value and fundamentals to those of other global auto makers – starting with the top 20 by market capitalization.
Tesla accounts for nearly 6 per cent of the market capitalization of the top 20 auto makers globally, but less than 1 per cent of the book value, sales, and gross profit. Yes, the company is growing revenues much more quickly than most other auto makers, but for Tesla's share of sales to match its share of market value, it would have to increase its revenues by more than 700 per cent. Perhaps that's doable, but if 700 per cent growth is already reflected in its valuation, Elon and Co. will have to deliver other fundamental improvements to drive good shareholder returns.
That will be challenging, especially if other auto makers have something to say about it. And they do. Every one of the world's top 10 auto makers already has plug-in hybrid or electric vehicles on the road. Cumulatively, the best-selling plug-in electric is Nissan's Leaf, with more total shipments than all of Tesla's models combined since Tesla's inception – to say nothing of the millions of conventional vehicles Nissan sells every year. Yet the market says Nissan is worth 15 per cent less than Tesla, valuing the Japanese firm at less than eight times its (positive) earnings and for less than its book value – and Nissan's book value is 10 times Tesla's.
Increased competition is not the only challenge Tesla faces. Manufacturing cars is a skill, and one which Tesla is still learning. Production for the company's mid-sized Model 3 has repeatedly missed targets, as manufacturing has been slower than expected. Existing auto makers have honed their manufacturing processes over decades. The best facilities run like the well-oiled machines they build: After joining Toyota, Gill Pratt, an executive from the U.S. Defense Advanced Research Project Agency – no slouch in technical expertise – quipped that "Toyota is the world's best manufacturing company. They just happen to make cars." Toyota intends to keep making them, and in addition to the company's leading position in hybrids, it is at the forefront of research into solid state battery technology. This could be transformative for Toyota – and the industry – as the technology would allow for smaller, cheaper and more energy-dense batteries than those in use today.
None of this is to say that Tesla's growth potential isn't bright. But if the company's valuation reflects an excellent chance of extraordinary growth and profitability, even strong growth and profitability could lead to disappointing returns for investors. We're not suggesting that there's nothing to get excited about with Tesla – it may very well become a winning company – but at current valuations, we worry about the odds that it represents a winning investment.
Though their growth prospects may be lower, we believe selected "incumbent" auto makers offer shareholders a much better chance of attractive long-term returns. Honda, for example, has a similar market capitalization to Tesla, but 12 times the sales, 13 times the gross profit, and 14 times the tangible book value. Tesla has repeatedly diluted shareholders by issuing new shares, while Honda uses its free cash flow to buy back shares and pay out dividends to shareholders. In its decade of existence, Tesla has never been profitable, and in the last four decades, Honda has never been unprofitable. Tesla's latest results showed a record loss, while Honda has delivered record profits over the past 12 months. Yet, like Nissan, Honda trades for less than eight times its earnings and less than its book value.
These companies may not be grabbing headlines like Tesla and its charismatic leader. But at these valuations, we'd rather pay for profits than promises.
Chris Horwood, MBA, is an investment counsellor at Orbis Investments and is responsible for the firm's institutional business in Canada.
How Tesla stacks up
|Trailing 12-month fundamentals (US$ billions)||Market cap.||Tangible book value||Sales||Gross profit||Net profit||Free cash flow|
|Top 20 global auto makers*||925||573||1,699||304||107||53|
|Tesla’s share of top 20||5.7%||0.7%||0.7%||0.7%||Negative||Negative|
Source: Bloomberg, Obits
*Top 20 ranked by market capitalization. Top 20 numbers are aggregates. Data as of March 19.