Tesla just released the results for Q4’22. Both earnings and revenue beat analysts’ consensus forecasts. In addition, CEO Elon Musk stated that he anticipated the firm would have the capacity to produce 2 million automobiles in 2023.
The earnings announcement is extremely important. Keep in mind that as recently as last September, Tesla’s stock price was above $300, and yet by the end of the year had declined below $110. Since the turn-of-the-year, the stock has surged more than 30%, while the S&P 500 rose by less than 5%. Against this backdrop, the Q4’22 results have produced a significant momentum effect for the firm’s stock; and the momentum effect is well documented and no statistical illusion.
In after hours trading following the announcement, Tesla’s stock price rose 5% to about $150.
Economist Robert Shiller, in his book Narrative Economics, tells us that narratives are important for the way investors think. The case of Tesla is a great example. The narrative for Tesla centers on Elon Musk, one of the greatest entrepreneurs of the century. Musk has an outsize personality and enormous self-confidence. In the course of a decade he built a successful fast-growing global electric vehicle company from the ground up to combat global warming.
This is quite a narrative, which propelled Tesla to attain the highest market valuation among automobile manufacturers, despite its relatively low volume.
In August 2022, Tesla split its stock 3-for-1. Typically, stock splits are followed by positive price trends, not the reverse. So, what happened to Tesla’s stock price during Q4?
In a nutshell, the narrative got dented. That dent was largely self-inflicted, when Musk purchased Twitter, and proceeded to gut it. The associated destruction in Twitter’s value took considerable luster off of Musk’s reputation, and it distracted him from running Tesla. In addition, evidence began to grow that demand for Tesla’s vehicles was beginning to slow relative to supply, particularly in China.
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Keep in mind that Tesla’s narrative does feature fundamentals, not just Musk’s reputation. Tesla’s stock price rose in January because Tesla cut the prices of some of its vehicles, which spurred demand, partly because of related tax incentives in the US. At the same time, Musk’s reputation has suffered additional damage from being on trial for having erroneously announced in a tweet during 2018 that he had secured funding to take Tesla private at a price of $420.
Just after Musk’s $420 tweet, I wrote a blog post explaining why a $420 valuation was well above Tesla’s fundamental value at the time. I also pointed out that being overvalued on fundamentals does not necessarily support a prediction that Tesla’s stock price would imminently decline. The sentiment factor can be huge, and in the case of Tesla is huge.
Just last month, in December, The Wall Street Journal ran an article explaining that even at half price, Tesla stock was no bargain. That was on December 12 when Tesla stock closed at $168; and Tesla’s current stock price is below that.
The Wall Street Journal article makes three important points about Tesla’s valuation. The first two relate to ratios. Specifically, on December 12, Tesla’s forward P/E ratio was approximately 32; and its PEG ratio was less than one, suggesting that Tesla’s stock was actually undervalued.
Ask yourself what these ratios imply in the world of textbook finance, where valuation is based on fundamentals.
For P/E, it means that unless Tesla’s projects can be expected to earn considerably more than the company’s cost of capital, Tesla’s shareholders can expect to earn a return of 3.1% (=1/32) per year going forward.
For PEG? Well, PEG means nothing about undervaluation to Tesla’s shareholders, as PEG is irrelevant in the world of textbook finance valuation. PEG-ratio pricing implies that P/E is proportional to the expected long-term earnings growth rate; and this is inconsistent with textbook finance which implies that P/E is determined by a stock’s beta and the proportion of the firm’s stock valuation which is associated with positive net present value projects.
The third point made in The Wall Street Journal article is that Tesla’s stock price has always been difficult to explain by the company’s fundamentals; and the fundamental approach relies on discounted free cash flow analysis.
There are few analysts who follow Tesla that actually use discounted free cash flow analysis. An exception is the team at JP Morgan. At the start of the year, they reported setting a price target for Tesla of $125 a share. By January 17, Tesla’s stock price already exceeded $125.
In 2019, I published an article in the Journal of Portfolio Management about overvalued stocks, and included Tesla in the group. By overvalued, I mean that the market value exceeds the corresponding fundamental value based on free cash flow analysis.
Behavioral economists accept that psychological factors can drive a wedge between market value and fundamental value, and that this wedge can be large and persistent. Investors who buy and hold for the long-term would do well to focus on fundamental value. However, investors with shorter investing horizons need to pay careful attention to sentiment, meaning the psychological factors that drive market prices.
In my Journal of Portfolio Management article, I analyzed the FAANG stocks: Facebook/Meta, Amazon
, and Google/Alphabet. I pointed out that all of these stocks were overvalued on fundamentals, largely because investors erroneously believed that in the long run each one could earn more than its cost of capital. Now, as tech stocks have been sliding dramatically in market value, investors have been realizing that doing so is highly unlikely, especially for large firms.
In my Journal of Portfolio Management article, I pointed out that investors have been implicitly assuming that Tesla will earn more than its cost of capital in the long run, the same as with FAANG stocks.
It is highly likely that one day, investors will draw the same conclusion about Tesla that they are currently drawing about FAANG. However, given the strength of Tesla’s current narrative, that day is not today.