Musings on Markets Fri, 07 Feb 2020 01:03:00 GMT language
- The Growth Lever: The revenue growth rate controls how much and how quickly the firm will be able to grow its revenues from autos, software, solar panels and anything else that you believe the company will be selling. Rather than focus on the growth rate, I would suggest looking at the estimated revenues in 2030 (ten years out). In my Tesla story (valuation), I have estimated revenues of $125 billion in 2030, a five-fold increase over the 2019 revenues.
- The Profitability Lever: The target (pre-tax) operating margin determines how profitable you think the company will be, once its growth days start to scale down. Since these are operating margins, not gross or net margins, they are after all operating expenses (cost of goods sold, SG&A etc.) but before any financial expenses (interest expenses). In keeping with my view that R&D is really a capital expense, I capitalize R&D, which improves Tesla’s profitability, and target an operating margin of 12% by 2025.
- The Investment Efficiency Lever: To grow, companies have to invest in production capacity and the sales to invested capital drives how efficiently investment is done, with higher sales to capital ratios reflecting more efficiency. With Tesla, I assume that every dollar of investment (in new factories, technology and new R&D) in the first 5 years generates $3 in revenues, as it utilizes excess capacity in the early years, and that this efficiency drops back by a third, as capacity constraints hit.
- The Risk lever: There are two inputs in this valuation that incorporate risk. The first is the cost of capital that I start the valuation with, a reflection of risk as seen through the eyes of a diversified investor in the company. The second is the likelihood of failure (or distress), where the company has to liquidate assets and lose the additional value that it could have generated as a going concern. With Tesla, I set this cost of capital at 7% and assume that given its marginal profitability and significant debt load, the chance of failure is 10%.
|Source data: S&P Capital IQ|
|Source data: S&P Capital IQ|
With this background, I think that you have the ammunition you need to make your own revenue judgments for Tesla in a decade, differentiating your story from mine, where revenues in 2030 for Tesla are roughly $125 billion. So, with no further ado, here are your choices (pick one):
|Source: S&P Capital IQ|
Broadly speaking, there are four broad stories that I have valued here:
- The Big Auto Story: If your story is that Tesla will emerge from its growth period as one of the largest auto companies in the world (revenues of $100- $300 billion in year 10), with top-tier auto company margins (7.42%), investment efficiency (2.42) and cost of capital (6.94%), the value per share ranges from $106/share (with BMW like revenues) to $227/share (with Daimler-like revenues) to $333/share (with VW/Toyota like revenues).
- The Techy Auto Company Story: An alternate story is that Tesla is an auto/software/services company with tech company characteristics, giving it higher margins (10.25%) and a higher cost of capital (8.86%). With this story, the value per share ranges from $111/share (with BMW like revenues) to $212/share (with Daimler-like revenues) to $298/share (with VW/Toyota like revenues). Put simply, the higher risk nullifies the benefits of higher profitability.
- The FAANGy Auto Company: In this variant of the tech story, Tesla not only develops a tech twist, but becomes as successful as the most successful tech companies (I use the FAANG stocks + Microsoft). In this story, the margins approach 18.97% and with a tech cost of capital, the value per share ranges from $459/share (with BMW like revenues) to $855/share (with Daimler-like revenues) to $2,106/share (with VW/Toyota like revenues).
- The Make-your-best Company: In this variant, I give Tesla the best possible outcomes on each variable, revenues like VW/Toyota, margins like pure software companies (21.24%), a sales to capital ratio that is higher than any of the sector averages (4.00) and a cost of capital of an auto company (6.94%), and arrive at a value per share of $2106.
- With the big auto stories, the key question will be whether Tesla can climb to the very top of the heap in terms of revenues, generally reserved for mass market companies, while earning operating margins that are usually reserved for smaller luxury auto companies?
- With the techy auto stories, the key question becomes whether a company that derives the bulk of its revenues from selling cars be profitable and reinvest like a tech company?
- With the FAANGy stories, the investment question becomes whether you should up front for a company on the expectation that it will be an exceptional company. It very well might make it to the top of the heap, but if it does not, you are set up for disappointment.
- With the MYB story, you are approaching the most dangerous place in valuation, where you pick and choose each assumption, without considering the ones you have already made. Put simply, is it even possible to build a company that generates revenues like Toyota, earns margins like Microsoft and invests more efficiently than any manufacturing company in history has ever done, while still preserving the low cost of capital of an auto company?
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