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Up 104% YTD, Has Tesla Stock Run Too Far Too Fast?

Motley Fool - Sat Sep 9, 4:47AM CDT

Tesla(NASDAQ: TSLA) stock has more than doubled in 2023, which is a massive move for a company that size. But since the beginning of 2022, Tesla is still down 27%, which shows how far the stock fell last year.

Let's look at where Tesla stock is, how it got here, a fair price for the stock, and where it could be headed to see if the growth stock is worth buying now.

A person smiles while hanging out of a car window next to a large body of water.

Image source: Getty Images.

The fundamentals are intact

At the beginning of the year, Tesla stood out as the best electric vehicle stock to buy. Looking back on that argument, there's very little that has changed about Tesla as a company.

Tesla still has the best balance sheet in the auto industry. Its quarterly operating margin did fall below 10% and its trailing 12-month (ttm) operating margin is now over three percentage points lower than the 17% operating margin Tesla posted in 2022. But overall, margins are still good. And a decline in margins was expected because of price cuts.

Despite a challenging period for automakers, Tesla is still growing extremely quickly. In the first half of 2022, Tesla produced 563,987 cars and delivered 564,743 cars. In the first half of this year, it produced and delivered 920,508 cars and 889,015 cars, respectively. That's a staggering 63% growth rate in production.

As for the financial performance, Tesla's ttm revenue is approaching the $100 billion mark. But profits have stagnated, impacted by higher operating expenses and capital expenditures. Overall, Tesla is doing very well, and the blemishes (lower margins and slowing profit growth) are mostly just as a result of the business cycle -- not a change in consumer sentiment toward EVs.

Finding a valuation that makes sense

The thing that has changed is Tesla's valuation. At the beginning of the year, Tesla's forward P/E ratio was in the high 20s, which made it similarly valued to some top consumer staples companies like Coca-Cola, McDonald's, and Procter & Gamble -- not other growth stocks. The discount didn't last that long. And now, Tesla's P/E ratio, price to sales (P/S) ratio, and price to free cash flow (FCF) ratio have skyrocketed, along with just about any other valuation metric you want to use.

TSLA PS Ratio Chart

TSLA PS Ratio data by YCharts

Part of the issue is that Tesla isn't growing profits right now. And its FCF is down because it is reinvesting so much in the business. Tesla stock's run-up also boosts the P/E ratio.

The million-dollar question for any stock is finding a fair valuation relative to the future performance of the company. Tesla has always been a volatile stock. So it's not surprising that it can look wildly expensive or cheap at any given moment. And there's no denying it simply isn't the bargain it was at the beginning of the year.

But given how fast Tesla is growing, its brilliant execution, its plans for production capacity expansions, and the long-term runway for electric vehicles, the stock definitely deserves to trade at a big premium to the market.

Focus on the P/S ratio

Revenue may be the best number to look at for Tesla, because it encapsulates how many cars Tesla is selling rather than how much it is spending in a given short-term time frame. And ultimately, Tesla's ultra-long-term investment thesis centers around exponential production growth and becoming the largest car maker by volume in the world. So assuming Tesla maintains its strong margins over time, the price to sales ratio is the valuation metric to look at for a good buy point in the stock.

Coincidentally, Tesla's current P/S ratio is almost exactly its 5-year average P/S ratio. But it's a lot lower than the 3-year average.

TSLA PS Ratio Chart

TSLA PS Ratio data by YCharts

For a company with 50% revenue growth and an over 15% operating margin, a 10 P/S ratio is a steal. Even if Tesla's revenue growth is closer to 30% over the next five years, a 10 P/S ratio is still reasonable if it keeps its margins up.

As a rough rule of thumb, I'd say the buy zone for Tesla is anything below a 10 P/S ratio. But again, if Tesla's revenue growth or margins show signs of deterioration, then this level should change.

Tesla stock is a good deal

The beauty of a fast-growing stock like Tesla is that it can start to look very cheap if its fundamentals stay strong. For example, for Tesla to maintain the same 10 or so P/S ratio, the stock price growth would have to match the revenue growth. So if Tesla grows revenue by 50% in 2024 compared to 2023, but the stock price is the same, the P/S ratio will be cut in half and be under 5. Similarly, if Tesla grows revenue by 50% but the stock doubles, then the P/S ratio will be higher.

The big takeaway here is that if -- and this is a big if -- a 10 P/S ratio is a good valuation for Tesla, then the stock should grow at the same pace as its revenue. 30% revenue growth would mean a 30% gain for the stock to keep the same P/S ratio. And so on. That's a compelling reason to own Tesla over the long term.

The good news is that Tesla doesn't even have to deserve a 10 P/S ratio to be a good buy. Even if a 7 or 8 P/S ratio is more reasonable, Tesla stock would still be a big winner if it can grow revenue at over 30% a year. Assuming 30% growth per year would give Tesla $349 billion in revenue in five years. Slap a 7 P/S ratio on that figure, and Tesla would have a market cap of $2.44 trillion -- more than three times its current $800 billion market cap. Play around even more with the numbers, and a 3 P/S ratio would be breaking even on the investment in five years, and a 5 P/S would still come close to doubling your money.

In sum, Tesla is a no-brainer investment if it can do even a 30% sustained top-line growth rate. But it's growing revenue by even more than that right now.

A growth stock worth owning

Tesla is a great buy for just being a car company. Once you start to consider all the other projects it has in the works, and the many ways it can monetize its technology -- robotaxis, artificial intelligence, solar energy, DC charging, etc. -- then the upside is too good to ignore.

Tesla isn't as screaming of a buy as it was at the beginning of the year. But until it shows signs of slowing down, there's no reason to get off this rocket ship of a growth stock.

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Daniel Foelber has the following options: long September 2023 $146.67 calls on Tesla and short September 2023 $150 calls on Tesla. The Motley Fool has positions in and recommends Tesla. The Motley Fool has a disclosure policy.

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