Tesla: A Review Of Damodaran's Valuation Model
Aug. 1.17 | About: Tesla Motors (TSLA)
In 2014, two business professors made bold predictions about the future value of Tesla.
Their discounted cash flow valuation model showed that Tesla was overvalued by 150 percent at the time.
I review the accuracy of their predictions and update the model based on current data.
On April 28, 2014, Aswath Damodaran and Bradford Cornell published a paper that examined the run-up in the price of Tesla stock (NASDAQ:TSLA) between March 22, 2013, and February 26, 2014. The coauthored paper – Tesla: Anatomy of a Run-Up Value Creation or Investor Sentiment? – was published in the Journal of Portfolio Management and won the Bernstein-Levy readers’ award.
The paper included a detailed discounted cash flow valuation model that was used to judge whether the price run-up was anchored in fundamentals or the result of investor sentiment. Based on the valuation estimate, the authors concluded that the stock was overvalued by approximately 150 percent. Both the article and the Excel valuation model are available to the public for free.
In this article I attempt to update the authors’ valuation model based on a rational evaluation of today’s facts at hand. In the process of updating the model inputs I evaluate the accuracy of the authors’ original predictions. I conclude with an assessment on whether Tesla is still considered overvalued.
Estimating Future Revenue Growth
The first step in forecasting cash flows is to estimate future revenue growth. This is arguably the most critical assumption in a valuation model. Most DCF models assume a period of supernormal growth (typically five years) followed by a sustainable long-term rate. In the publication, the authors estimated an annual growth rate in revenues of 70% for five years. They admittedly noted that this estimate was aggressively optimistic.
Source: Based on data from Tesla’s Form-10Ks and cited article.
Now that three and a half years have passed, their estimates look high in hindsight but surprisingly close. For reference, a forecast of 60% annual revenue growth would have tracked the closest to reality. (For any readers following the article, note that Damodaran and Cornell made their predictions in September of 2013, meaning they had two quarters of actuals for the year. In order to align their annual predictions with the fiscal year of Tesla, I used a growth rate of 35% for the remainder of 2013).
For the ease of simplicity, I similarly apply a 70% growth rate in revenues for Tesla over the next five years to the updated valuation model. I too believe this is optimistic but in line with recent company history.
When estimating the sustainable growth rate, the authors chose to use the long-term risk-free rate. This was selected because yields on riskless debt tend to track aggregate economic growth in the long run. Their valuation model consequently assumed that revenue growth would decline linearly from 70% after five years to 2.75% by year ten.
At the time of writing (7/29/2017), the 10-year Treasury risk-free rate was 2.30%. In the context of my valuation model I therefore assume revenue growth of 70% for the first five years which then converges to 2.3% after ten years. At these growth rates, Tesla revenues would increase to $416.2 billion by mid-2027. This represents a market share 274% greater than that of Ford (NYSE:F) today and 250% greater than General Motors (NYSE:GM).
Estimating Future Operating Profit Margins
The next input to the valuation model is the expected change in operating profit margins. To estimate Tesla’s future margin, the authors looked at the company's current results in addition to the average for the industry. The authors again chose an aggressively optimistic forecast in order to make the strongest bear case possible. They assumed Tesla’s current operating margin of -1.64% at the time would rise to 12.5% over 10 years. This would put Tesla in the 95th percentile for the auto industry and among the likes of Porsche, “one of the most profitable automobile manufacturers."
Source: Based on data from Tesla’s Form-10Ks and cited article.
Damodaran and Cornell were right about being excessively optimistic. In the subsequent three years since publication the operating margin of Tesla actually decreased, never entering positive territory. I therefore have chosen to be slightly more conservative in my estimate by using 10.0% as my terminal operating profit margin. This figure is similar to what Toyota (NYSE:TM) achieved in its fiscal years ending 2016 and 2015. By comparison, Ford, GM and Honda (NYSE:HMC) had operating profit margins of 2.7%, 5.7%, and 6.0% (respectively) in their most recent fiscal years.
Estimating Future Tax Rates
Predicting the effective tax rates for Tesla is particularly difficult since the firm has historically operated at a loss and paid minimal income tax expenses (i.e., paying between 0% and 4% of annual pre-tax income). In their original valuation model, Damodaran and Cornell assumed the firm would have an effective tax rate of 0% for five years after which point the rate would increase linearly to 35% over the next five years. Under my revised model, Tesla does not show operating profits until the sixth year. I have therefore modeled Tesla’s tax rate progression equivalent to that of the authors.
Estimating Future Capital Investment
The last estimate required before calculating free cash flows to the firm (FCFF) is the amount of capital reinvested into the firm to grow future business. Invested capital is defined by the authors as net property plant and equipment (PP&E) plus working capital, where working capital is non-cash current assets less non-debt current liabilities.
The authors assumed in the context of their valuation that Tesla’s incremental investment in capital would be 71% of revenue growth (or a sales-to-capital ratio of 1.41). Their estimate was based off of industry averages. History shows that Tesla moderately surpassed the authors’ expectations on this account. Tesla had reinvestment rates in 2016, 2015 and 2014 equal to 46%, 141%, and 96%, respectively.
Source: Based on data from Tesla’s Form-10Ks.
In order to remain internally consistent with revenue growth and operating margin estimates, I have chosen a capital-to-sales ratio of 70% for the next five years. This is equal to the average reinvestment rate of Toyota over the past five years (the same company I used as a basis for projecting future operating profit margins). I then assume reinvestment rates come down to 40% by 2027.
Based on the forecasted level of after-tax operating income and invested capital, Tesla would have a return on invested capital (ROIC) of 11% by the end of the explicit forecast period. This is 127 basis points short of the authors’ original estimate. I next assume a reinvestment rate equal to 28.75% of after-tax operating income when calculating the terminal value as the authors did. This is consistent with a sustainable growth rate of 2.3% (= Cost of Capital * Reinvestment Rate = 8.0% * 28.75% = 2.3%).
Discounted Cash Flow Model
In the updated discounted cash flow model displayed below, Tesla does not achieve positive free cash flows to firm (FCFF) until year ten. This is consistent with the original valuation model developed by Damodaran and Cornell. As a result, almost the entirety of Tesla’s value is realized in the terminal year. This is not entirely unlike most valuation models.
Summing the present value of future free cash flows yields a firm operating value of $32.02 billion. After adding a cash balance of $4.10 billion and subtracting debt of $8.17 billion, the value of equity comes to $27.94 billion. The estimated per share value of equity, assuming 162 million shares outstanding, is therefore $172.36.
At the time of writing (7/29/2017), Tesla had a market price of $335.07 per share. Based on the intrinsic value estimate of $172.36 generated by the valuation model, Tesla stock would be overvalued by approximately 194 percent. This would imply that the price and rational value of Tesla have significantly diverged.
In this article I have followed the authors' valuation method in recreating their original model based on up-to-date information. The resultant value implies Tesla is significantly overvalued. This was the same conclusion formulated by the authors of the paper.
Whenever I estimate an intrinsic value estimate at great odds from the market, my default reaction is to believe that the market has it right and I have made an error. Perhaps the greatest risk to the model is the very low terminal growth rate of 2.30 percent. Based on the current price, the market is implicitly assuming a 9.46% long-term sustainable growth rate (assuming all else equal in the model). I believe the growth assumption of the market is overly optimistic but perhaps closer to rational expectations than the 2.3% previously presented.
Another material lever of the final valuation is the operating profit margin. For example, preserving the long-term growth rate at 2.3% and moderately increasing the operating margin from 10.0% to 12.5% (the original estimate of the authors) yields a per share value of $469.71. At this figure, Tesla would be undervalued by 71 percent. For reference, a long-term operating margin of 11.37% would make Tesla fairly valued.
Clearly the valuation model is sensitive to key input changes. However I believe the model reveals that Tesla is fairly priced only under the most aggressive revenue and margin assumptions. This makes Tesla appear like a risky investment, a conclusion almost no one will be surprised to hear.
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.