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Tesla has a business model problem: It can never justify its current stock price by simply making cars

August 29, 2020, 11:00 AM UTC

You can be forgiven for not knowing what to make of Tesla’s amazing run and the battling views on whether it can keep racing. Fans are cheering Elon Musk’s speedster from the home side of the bleachers, and naysayers are blasting boos from across the track. Boosters such as Ron Baron, chief of major shareholder Baron Capital, recently forecast that Tesla will mushroom to “at least $1 trillion in sales” over the next 10 years, while a legion of noted short-sellers, including Jim Chanos of Kynikos Associates, were betting big against the electric-car maker when it was far cheaper, and fared poorly when its shares went on a tear. Chanos remains a skeptic, remarking that “Tesla’s not a market leader. The product at Tesla that’s always been first-rate is the narrative.”

Indeed, the more than ninefold jump in Tesla’s shares since September 2019, lifting its valuation from $45 billion to $417 billion—capped by a more than doubling from $200 billion at the end of June—ranks as one of the most astounding performances in the annals of capital markets.

But Tesla is still the glamour model in the ultracompetitive, capital-intensive, mainly slow-growth business of building and selling cars. As this writer noted earlier this year, in a blindfold test, most investors would probably balk at Tesla’s numbers. Tesla’s being touted as a go-go player in the antithesis of a go-go sector. So here’s the question that folks and funds pondering an investment in the EV maker should be asking: Over the next several years, what’s the valuation Tesla must achieve to reward them for shouldering the heavy risk of buying its shares right now? The answer depends largely on how many electric vehicles it needs to sell going forward, and whether achieving those volumes is remotely plausible, considering that at least half-a-dozen rivals with big plans for their own EVs will be vying for the same customers.

The short answer is that given the current size and projected growth of the industry, Tesla can’t get there. It would have to put an impossibly large number of customers behind the wheel. It’s not that Tesla can’t be successful. The killer is that its bubble valuation mandates future performance that simply looks unachievable.

As always, a high-flier’s towering market cap doesn’t tell you how it will perform, but does determine how it has to perform to make you money. Its valuation sets the speed that a racer must beat. In the future, Tesla’s wheels may not come off, but it can’t go fast enough to win for new investors.

Let’s be conservative and assume you’d want a 7% annual return on Tesla. That’s hardly great when you weigh the big starting price and the wildly divergent views on how its stock will fare. We’ll further predict that as a vaunted growth play, Tesla pays no dividends and reinvests all of its profits to stoke growth. In that scenario, its valuation would need to double in 10 years, from today’s $417 billion to around $834 billion by mid-2030.

How much would Tesla need to earn 10 years hence? That depends on its price/earnings ratio looking ahead. It’s unlikely that any big automaker can remain a runaway growth machine after decades in the business, but we’ll give Tesla a generous multiple of 25 in 2030, meaning that investors still expect it to wax at better-than-industry rates. In that case, Tesla would need to post $26.4 billion in GAAP net earnings by the summer of 2030 ($33.4 billion pretax, less corporate rate of 21%).

Let’s put that $26.4 billion bogey in 2020 dollars, to better compare where Tesla needs to go alongside the status of its present and future rivals. At 2% inflation, the $26.4 billion equates to $21.64 billion. That’s a heck of a number, considering that Tesla posted a loss of $862 million in 2019, and generated a modest $799 million in free cash flow—a figure dwarfed 462 to 1 by its market cap.

But Tesla isn’t just a car company. It’s getting 15% of its revenues from energy generation and storage, and services. We’ll assume Tesla generates 85% of its sales and profits from cars in the future. In that case, its profit would hit $18.4 billion (85% of $21.64 billion) in our success road map in 10 years.

How big would Tesla’s sales need to grow to generate $18.4 billion in net profits, measured in 2020 dollars? Over the past several years, the top net margins garnered by the world’s major automakers were in the mid-8% range, posted by BMW and Toyota. We’ll act like a Tesla believer and predict that it will achieve a margin of net income to sales of 9%.

That math puts Tesla’s 2030 revenues at $204 billion, once again, in today’s dollars. That’s around three-quarters the size of the two biggest carmakers measured by 2019 revenue, VW ($280 billion) and Toyota ($275 billion).

Sounds unlikely. Last year, Tesla posted $24.6 billion in revenue. To reach $204 billion by 2030, its sales would need to jump 23% a year, adjusted for inflation (or 25%, adding a 2% annual increase in the CPI).

Keep in mind that Tesla isn’t a mass-market purveyor like VW and Toyota. Its speciality is pricey models. In 2019, it booked $57,600 on average on the autos it delivered to customers. So by today’s standards, what volume of cars would get Tesla to our goal of making you money?

It would take sales of 3.5 million EVs—each generating today’s $58,000—to achieve $204 billion in sales. Is it doable? Global revenues for the entire luxury car universe in 2019 amounted to roughly $650 billion and by 2030 would be around $860 billion in real terms. So Tesla would need to capture roughly one-quarter of the total market in ten years. Last year, its dollar share was less than 4%. The entire sector would probably reach 10 million vehicles, so that Tesla would be selling over one in three of the world’s high-priced autos.

To make the numbers, Tesla needs to conquer an additional one-fifth of the entire global luxury car market. That’s 25 points of market share that the likes of Daimler and BMW would lose. A shift even half that big seems impossible, since these rivals will battle Tesla for every point by lowering prices, improving road performance, and adding features.

Tesla fans argue that it enjoys great “optionality.” It could generate big sales and profits outside of selling Teslas by supplying batteries to other carmakers, or deploying new technologies. It’s important to note, however, that our analysis assumes that the non-car, 15% of Tesla’s business also grows at gigantic, 20%-plus rates in the future. If it doesn’t, Tesla will have even more trouble hitting the targets.

In a sense, Tesla will be a victim of the zealots who sent its stock price on a moonshot. Their overoptimism has made it impossible for today’s investors to profit. Tesla stock could someday be a good deal, but only if it suffers a drop as jaw-dropping as its rise.