Looking Under the Hood of Tesla’s Valuation

SMITH BRAIN TRUST – How do you make sense of Tesla? It’s a Wall Street darling, but with completely puzzling fundamentals. CEO Elon Musk is a bold innovator, and his company has made an aspirational vehicle line, with sticker prices to match. Still, profits mostly elude the company.

We recently sat down with Brent Goldfarb and David A. Kirsch, associate professors of business and entrepreneurship at the University of Maryland’s Robert H. Smith School of Business and co-authors of “Bubbles and Crashes: The Boom and Bust of Technological Innovation,” to look under the hood of the all-electric vehicle maker. Here’s what they had to say.

Q: Is Tesla the next Apple, or is it Bitcoin?

Right now, Tesla is closer to Bitcoin than to Apple. The volatility of Tesla stock is reminiscent of Bitcoin’s wild price swings. In the case of Bitcoin, these were evidence of Keynes’ “animal spirits” in action, and Tesla’s recent stock behavior seems similarly untethered from underlying business fundamentals. Yes, Apple and Tesla are both hardware companies (loosely defined), but unlike Apple – which has been very profitable over the past decade – Tesla has yet to have a single profitable year since it was founded in 2003. Instead, even with a recent $2 billion capital raise, its balance sheet is stuffed with accumulated deficits and unanswered questions.

Q: Is Tesla’s stock worthy of its valuation, or is it, as many suspect, priced in bubble territory? Are there any special reasons to support Tesla’s high stock price and market value?

Opinions vary widely about the underlying value of a share of Tesla stock. As a result, volatility has been very high, even after accounting for a general rise in volatility associated with the outbreak of COVID-19. Tesla had some signs of strength, including two consecutive marginally profitable quarters. However, there are strong warning signs that demand was lagging prior to the COVID-19 hit, and the continuation and expansion in profitability needed to support the P/E ratios implied by the recent stock run up is almost impossible. It is hard to see how Tesla will not incur severe losses in the next two or more quarters because honestly, who is buying a new car right now? These losses will only be fatal if there is also a loss of confidence in Musk because otherwise we expect that he will be able to raise more money on the capital markets.

Q: Let’s assume the electric vehicle market is about to become very crowded, with major brands launching battery-powered models to meet European and Chinese emissions targets. Can Tesla maintain its early lead when other electric vehicles enter the mainstream?

Maybe. Future market leadership is exactly what investors who purchase Tesla shares are banking on. That is the only possible justification for the recent price behavior of the stock. If the Model 3 becomes that must-have hit, then this is possible. And so far, the Model 3 is the only runaway electric hit; most other electric vehicles are experiencing modest market success, at best. However, part of the problem is that the Model 3 is too good for the money, and this inevitably squeezes profit margins, suggesting that over time, the mainstream manufacturers should be able to better compete with Tesla.

Q: Do you see Tesla's Model 3 becoming the iPhone of the electric car field?

The analogy to the iPhone is probably not very helpful because there are legitimate network effects associated with the development of the iPhone ecosystem (that is, the more people use an iPhone, the more valuable my iPhone is to me and the more resources developers will commit to building new and valuable apps). There is not much reason to believe that Tesla will generate these kinds of benefits except at the margin (for instance, through access to proprietary charging systems or prevalence of Tesla-trained engineers). Yes, Tesla is becoming a type of standard – the exemplar that comes to mind when people are asked about an electric vehicle – but that alone does not necessarily translate into shareholder value.

Q: Some stock pickers adopt an “invest in people” concept, and many like what they see in Musk. Some have even referred to him as “the real-life Iron Man.” What is your view of Musk's personal charm and influence?

Musk is clearly a gifted entrepreneur, and his public persona is almost without parallel in the business world (among people known primarily for their success in business, only Bill Gates has more twitter followers than Musk). A recent book even compared Musk to Einstein. His ability to control the Tesla narrative has enabled the firm to accumulate resources on a scale that dwarfs that of all other electric vehicle startups. Musk has also been compared to transformative entrepreneurs like Bill Gates, Henry Ford and Michael Dell. However, in each of those cases, there was clear evidence of sustainable competitive advantage that generated long-run growth and profitability. Similarly, Musk’s celebrity and entrepreneurial skill will eventually need to translate into measurable profits for the firm.