Why Tesla’s Valuation Makes Se

Tesla Inc. (TSLA, Financial) has now joined the trillion-dollar club after its stock price zoomed up to surpass $1,000 per share yesterday on the back of news that Hertz Global Holdings Inc. (HTZZ, Financial) has ordered 100,000 of its electric vehicles.

Specifically, according to Hertz’s announcement, the company plans to offer “the largest EV rental fleet in North America and one of the largest in the world. This includes an initial order of 100,000 Teslas by the end of 2022 and new EV charging infrastructure across the company’s global operations.”

Tesla bears and those of us sitting on the sidelines have gotten yet another sticker shock from this company as it continues higher at a breakneck pace. Trading at a price-earnings ratio upwards of 300, the company accounts for more than half of the total market cap for U.S.-listed automakers according to the GuruFocus industry overview, despite revenue and net income being nowhere near the numbers of more established automakers.

As eye-popping as the continued gains are, though, they’re not surprising considering Tesla’s market position. In fact, unless specific conditions are met, the stock could very well continue on its dramatic uptrend even as competitors begin to ramp up their development and production of EVs.

The reason for this is because the market tends to assign growth stocks a valuation based on expected future growth, and although the future isn’t set in stone, the growth potential for Tesla is enormous. Add in the fact that every time a headline hits the news about climate change, EVs or improvements in Tesla’s deliveries, it contributes to a positive feedback loop that reassures shareholders their vision of the company’s growth will come true, and we can see why Tesla’s stock was destined for greatness.

EV market growth

According to a recent report from Meticulous Research, the global market for electric vehicles is expected to be worth $2.4 trillion by the time 2027 rolls around. That would represent a compound annual growth rate of 33.6%. Growth is being driven by government support, rising gas prices, increasing investments by automakers, concerns over automobile emissions and falling battery prices.

Driven by its dominance in the U.S. EV market and entry into new markets, Tesla has been growing even faster than the projected future growth rate for the overall EV market. In its most recent quarterly results, the company reported a staggering 97% year-over-year growth in automotive sales.

The market has an inherent fair-weather bias, especially with growing companies, so let’s say the market is expecting annual growth of 97% for all of Tesla, not just its top line. If Tesla truly can maintain 97% growth every single year for the next 10 years, in its bottom line as well as its top line, then the GuruFocus discounted cash flow estimates that this (incredibly optimistic) scenario would result in the current share price trading at a 92% discount to intrinsic value. At the bare minimum, the DCF calculator estimates that the company will need to grow its earnings per share at a rate of 51% per year for the next decade in order to be worth its current valuation.

In some ways, growth expectations for Tesla have become a self-fulling prophecy. The higher a stock is valued, the easier it is for the company to raise funds to invest in its business, thus making it easier to achieve the high levels of growth expected of it.

Global stumbling blocks

It is possible that the EV market may not grow as quickly as expected. The main stumbling blocks on the path to an EV future are lack of EV charging infrastructure and lack of electrical grid capacity. While the former is something that can be remedied by EV companies as they increase their production and sales, the latter is the more serious issue.

A higher number of vehicles drawing on the electrical grid would be fine if the electrical grid could support it. The problem is that many grids are outdated and in disrepair, especially in countries like the U.S., where electricity is a product rather than a service.

This electricity model discourages repairs and upgrades since utility companies are focused on earning as much of a profit as they can with as little investment as possible (look up the disasters caused by PG&E Corp. (PCG, Financial) if you don’t believe me). Unless something is done to increase grid infrastructure and grid capacity, an army of EVs could very well result in a higher frequency of power outages or even damage to the electrical grid.

That’s more of a long-term EV market problem, though. Tesla’s main problem is that it is losing global market share rather than gaining it. As of mid-2021, Tesla’s global EV market share fell 21%, tumbling all the way down to account for 13.9% of the EV market compared to 17.7% a year ago. While Tesla was reporting 97% growth, the global EV market grew 154%.

Wait, back up – isn’t Tesla’s 97% growth amazing compared to the expected future growth rate for the global EV market, which is a measly 33.6%? It is, but we can’t say Tesla is outpacing the rest of the EV market based on those two numbers. That’s comparing apples to oranges. It would be quite the feat to grow fast enough to make up for all the new players entering the market globally. The entire EV industry has received a huge boost as governments and investors are getting on board and the technology is becoming cheaper, easier and more profitable to manufacture.

The American share of mind

Even though Tesla has been losing global EV market share, its dominance in its home market has so far remained unquestionable. In full-year 2020, Tesla accounted for 79% of all new EVs registered in the U.S. As of mid-2021, registration data from Experian estimates that Tesla now accounts for 66% of the EV market in the U.S. General Motors (GM, Financial) follows distantly with 9.6%.

EVs now account for 2.5% of all vehicles sold in the U.S. after EV sales more than doubled in the first half of 2021, and in the minds of most Americans, the EV market is the same thing as the Tesla market, since almost all of the country’s EVs are made by Tesla.

In other words, Tesla’s valuation has benefitted enormously from what’s known in marketing as “share of mind.” A product’s share of mind refers to the degree of consumer awareness of the product, idea or brand, as well as the degree to which consumers equate the type of product with the company’s specific offering.

In its home market, EVs are the same thing as Teslas for most people, even if they don’t realize it on a conscious level. Thus, when we think about the prospect of all automobiles sold eventually being EVs at some nebulous time in the far-distant future, it would seem natural to extrapolate that Tesla will eventually supply 66% of all automobiles sold in the U.S.

More likely than not, an increasing number of competitors will prevent the above situation from developing. However, as of right now, competitors have not made any significant dents in Tesla’s U.S. market share, so the market is proceeding as if they will never make more headway.

A volatile valuation

To be fair, if Tesla really does still account for 13% of the global market share and 66% of the U.S. market share for EVs in 10 years’ time, the stock could still be massively undervalued at current levels, and that’s without accounting for Tesla’s other budding business ventures.

Even if it doesn’t maintain the same market share, if it can increase its earnings per share more than 50% per year over the next decade, it could grow into its current valuation over time.

Additionally, the stock will likely continue to trade at high valuation multiples for years to come before eventually settling into mature company ratios. Amazon (AMZN, Financial) has traded at price-earnings ratios in the hundreds or even thousands throughout parts of its history and has since settled into a multiple near 60; it doesn’t seem implausible that Tesla might do the same as earnings begin to grow faster than investor enthusiasm.

All things considered, I can understand why Tesla’s stock has had such a spectacular run. I even think it could continue climbing higher from here, although given the increasing competition, high volatility and loss of market share, I personally am not keen on picking up shares at $1,000 apiece.

In order for the market to really cool down on this stock, it would need to lose both market share and share of mind; when people think of EVs, they will need to stop immediately thinking of Tesla. By the time that happens, maybe the company’s earnings will have made progress in terms of catching up with the share price.