Earlier this year, in a Twitter discussion about which stocks Berkshire Hathaway should invest in, Elon Musk responded that it should be in a company whose name "starts with T...," suggesting that Tesla is still a worthwhile investment. He also recalled that Berkshire's vice chairman Charles Munger had a chance to invest in Tesla, valued at around $200 million when he had lunch with him in late 2008. Today, Tesla's capitalisation fluctuates between $520 billion and $540 billion, so up to 2,700 times more, and only 15 years have passed since then. Recently, the topic resurfaced as the men exchanged compliments but also differences of viewpoints in their approach to business. "He wouldn't have achieved what he has in life if he hadn't pursued unreasonably extreme goals," Munger said, stressing that Elon Musk has big dreams and solves impossible problems. Still, he and Buffett are looking for something different. Musk's way of doing things, means that he sometimes achieves great things yet often fails. Musk may be convinced that there is still a bright future ahead for Tesla, as electric cars make up a small percentage of automobiles compared to combustion cars. In contrast, a well-known and respected analyst, investor, and professor of finance at New York University, Aswath Damodaran who runs a popular investment blog and YouTube channel, argues that Tesla is overvalued. He is not suggesting that it is a bad company or has no future, just that it is currently too expensive. Does this mean a drop in Tesla's stock price could make it more attractive to investors like Damodaran? Or maybe even Berkshire Hathaway may be convinced?
Berkshire Hathaway's missed opportunity
When Buffett and Munger were getting the investment proposal, Tesla was not listed on the stock exchange yet. It became public only in 2010, and at that time, the share price was - taking into account the stock split - $1.28. Today, it's around $172, up 13,343% in 13 years. We can calculate the average annual increase relatively easily. First, we divide the current price by the initial cost; the result is 134,375. 13 years have passed since then, so we take the root of 13 out of this figure. This gives a result of 2.4802 and subtracts 1. What this means is that, on average, Tesla's shares grew by 148.02% over the year relative to their IPO date. Of course, it should be noted that Tesla did not grow steadily, its most significant increases began just before the coronavirus pandemic, and at its peak, the stock price was almost two and a half times what it is now. On the other hand, it should be noted that, as its capitalisation was $2.2 billion on its debut day, the value increased by a staggering 11 times in the nearly two years following Berkshire Hathaway's proposal, meaning that for each year the company credited - geometrically on average - an increase in value of more than 230%, calculating this using the same method as above.
Source: Tradingview
Instead, Berkshire Hathaway, through one of its subsidiaries, invested $232 million in BYD - Tesla's competitor from China. The holding company's stake in that company rose to more than $7 billion by early 2021, and the company has monetised well over $1 billion of BYD shares in recent months. Today, its capitalisation is at a similar level to 2 years ago. This is a substantial and very spectacular growth in which 30 times the amount invested was achieved, a fact that resonated with the investing world. Still, this is not several times, but in fact, many times more modest than the growth Tesla has experienced in this period.
Source: Tradingview
Damodaran valuation update
Aswath Damodaran has been keeping a close eye on Tesla since 2013, and admits in a January 26 blog post that he was wrong about pricing it every step of the way. He says that at first, he treated Tesla like an ordinary car company making luxury cars. He didn't see the growth potential in it, mischaracterised the product, and assessed it as too capital-intensive in terms of reinvesting profits.
Later, in June 2019, based on these factors and an analysis of profitability and sales growth indicators, he deemed the company undervalued, i.e. months before its strong growth from the covid period and the realisation of its potential in terms of its share price. However, he might have underestimated the extent of Tesla's growth potential. By his own admission, he "misplaced sales over time". The gains during the cover period appear to have exceeded his valuation. There are some differences in approach between Damodaran and Buffet. The former seems to take the approach of a financial analyst, looking more through the prism of the stock market and trading on it. Buffett could be seen as someone who has a strictly entrepreneurial approach, where the stock market is just a way of getting into a company that he finds attractive, and does not seem necessary for him either because he invests not only in companies that are listed but also in those that are not listed yet. There is an element of that in Damodaran's case, but they are different approaches.
Currently, the analyst continues to believe in Tesla's growth prospects as a company. Although much of its potential has already been achieved, it continues to do so and could become the largest car manufacturer overall, given the trend of replacing fuel-driven cars with electric ones.
The US equity market in January 2023 looks very different from early 2022, Damoradan notes. Rising risk-free rates and equity risk premiums have increased the cost of equity for all companies. The cost of equity is simply the minimum return we expect from a given investment. The idea is that an investment must be profitable for a given level of risk. Because there are better alternatives, the cost of capital is simply how much we expect from those alternatives under the given conditions.
Tesla, as can be seen from the text quoted above, is not only an exception, but perhaps more should be demanded of it as a company with above-average risk. The 6% cost of capital he used in November 2021, higher than the median cost of capital of 5.6% for US companies at the time, is no longer defensible as the median cost of capital has risen to 9.6%. He estimates that the cost of capital for Tesla should now be placed at 10.15%. This means that the required return on investment of Tesla's stock necessary to consider it a sound investment is higher. Damoradan's assumptions for Tesla's revenues are quite high, with a forecast of $400 billion in 2023. This compares with $81 billion for 2022, which would imply a sudden year-on-year revenue increase of several times that amount. It's worth noting that the valuation assumptions were adopted in January this year. Since then, first-quarter results have been released, with sales reaching $23 billion. This suggests growth, but not as much as Damodaran expected. If the company were to achieve such high annual results, it still has a lot of catching up to do and may not make it. Even if it did manage to reach a certain level, according to the assumptions described in the presentation as to turnover, profitability and the assumed cost of capital, Tesla's value turns out to be too high. The valuation results place it at $130 per share.
Will Aswath Damodaran change his valuation ? It is also worth considering whether such sales expectations are partly driven by the current market cap, which did not come out of nowhere. Other valuation methods also indicate that Tesla may be overvalued. For example, its P/E ratio has reached 45. In case that the company's profits for the next three quarters would be similar or slightly higher, with similar margins, the ratio level might be similar. In case that sales are at the level Damodaran expects and at existing margins, the ratio will be much lower. However, Damodaran himself emphasises that a strong increase in sales should be accompanied by a reduction in margins, as to increase sales, one should mostly reduce the price.
Paweł Szarmach, MPW, Market Analyst of Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement or an investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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