How Overvalued Is Tesla’s Stock, Really? (2024)

Despite Tesla’s TSLA stock having lost more than 60% of its value since November 2021, recent analyst reports from JPMorgan indicate that the stock would have to drop by an additional 35% from its current level to reach fundamental value. However, a behavioral analysis of the report’s methodology suggests that the number might be closer to 75% than 35%.

Two psychological elements underlie the behavioral analysis of the report. Both were emphasized by the late psychologist Daniel Kahneman. The first is downplaying base rates, and the second is representativeness. Base rates refer to the rates at which relevant events have occurred in the past. Representativeness is the misuse of stereotypic thinking.

Back Of The Envelope Calculation

While some investors like to dig into the details of analyst reports, many do not. For those who do not, this section presents a brief back of the envelope calculation to register the point about Tesla’s potential overvaluation. Readers who just want a quick sense of the issue can read this section and skip to the conclusion.

During April 2024, the JPMorgan reports on Tesla estimate that at the end of 2024, Tesla’s enterprise value will be $331,483 million. A key input in arriving at this value is an estimate of the minimum level of future profitability Tesla’s investors would find acceptable.

Here acceptable profitability is measured by a rate of return, the cost of capital. Actual profitability is measured by the return on invested capital. When they are equal, the firm is said to exactly earn its cost of capital.

The base rate issue is that in the long run, most companies do not earn more than their cost of capital. That is, return on invested capital does not exceed the cost of capital.

If the JPMorgan analysts expect that Tesla will exactly earn its cost of capital going forward, then there is a straightforward calculation to estimate its fundamental value at the end of 2024: Simply divide the estimate of Tesla’s 2025 value of EBIT after tax, or EBI, by Tesla’s weighted average cost of capital. The report also estimates Tesla’s EBIT during 2025 to be $12,792 million and its WACC to be 11.8%. The resulting ratio is $108,406 million, which is roughly one third of the JPMorgan estimate.

I suggest a reason why the JPMorgan estimate of enterprise value could be three times the estimate from the simple formula: The JPMorgan analysts assume that Tesla will earn much more than its cost of capital going forward. Is the assumption reasonable? The evidence presented below suggests not.

Tesla’s Return On Invested Capital

Prior to 2020, Tesla’s return on invested capital was negative. In 2020, it barely turned positive. However, in 2021, it rose to 14%, then to 23% in 2022 and then dropped slightly to 20% in 2023. Therefore, in the last three years, Tesla did indeed earn more than its cost of capital.

However, Tesla’s situation has changed. The JPMorgan analysts gave Tesla’s stock a recommendation of Underweight, indicating that Tesla’s deteriorating fundamentals relate to decreased demand for its vehicles, not decreased supply. The New York Times NYT describes how Tesla is now facing stiff competition for electric vehicles from American, Korean, Chinese and European automobile manufacturers, such as Ford, BYD, and BMW. These firms all have big EV product lines and growing sales. Indeed, during the fourth quarter of 2023, BYD briefly became the world’s largest seller of EVs.

Standard textbooks in economics and finance clearly state that for a company to earn more than its cost of capital in the long run, it must have some sustainable competitive advantage. Companies that earn more than their costs of capital attract competitors, and competition puts downward pressure on prices and profit margins. Tesla is now cutting prices and profit margins to compete with its competitors. Going forward, this decision will place significant pressure on the company’s ROIC.

Return On Capital, Base Rates, And Representativeness

Computing enterprise value requires a focus on the long run. Consider this question: Over the long run, what percentage of publicly traded companies earn more than Treasury bills? This is a question about a base rate.

Financial economist Hank Bessembinder’s work provides the answer, which is 4%. Think of 4% as the base rate. Put another way, over the long run, 96% of publicly traded stocks fail to outperform the Treasury bill rate.

Amazon AMZN and Apple AAPL earn more than Treasury bills. In May 2017, analysts at Morgan Stanley MS made the following statement: “The bull case on Tesla is that it can become the next Amazon or Apple.” The title of the report is “The Price of Ambition: Downgrade to EW.” Keep in mind that the simple valuation formula refers to companies earning their cost of capital, not earning the rate on Treasury bills. So, the question for valuing Tesla becomes whether it is reasonable to expect that going forward, the firm’s ROIC will match its 11.8% cost of capital. Given the base rate, the odds are against it.

In respect to representativeness, Amazon and Apple serve as stereotypes. Analysts and investors rely on representativeness for their judgments when they do two things. First, they view Amazon and Apple as emblematic of companies with the highest performing stocks. Second they make valuation judgements about Tesla based on their perceptions of how representative is Tesla of the class of companies having the highest performing stocks.

Discounted Free Cash Flow Analysis

The analysts at JPMorgan and Morgan Stanley do not use the simple valuation EBI/WACC-formula which I described above. Instead, they use a free cash flow counterpart, which applies a multiple to an estimate of a future free cash flow. For example, the JPMorgan analysts apply a multiple of 83 to their 2025-free cash flow estimate of $2,571 million for Tesla.

As a general matter, applying a multiple is fine, as long as the multiple is reasonable. The thing about using 83 is that it implies an expectation that Tesla will earn much more than its cost of capital going forward. That is why, I suggest, the JPMorgan estimate of $100 per share for Tesla’s fundamental enterprise value is too high.

It is straightforward to ascertain the value of the multiple corresponding to any firm exactly earning its cost of capital. First, estimate the long-term growth rate for the company’s free cash flow. Call this g. Compute the ratio (1+g)/(WACC-g). Now tie g to the assumption that the firm will exactly earn its cost of capital. The textbook formula for g in this case is g = retention rate x WACC. The retention rate is the ratio of a company’s capital expenditures net of depreciation to the sum of its unlevered free cash flow and capex net of depreciation. In theory, all variables in the analysis should be adjusted for inflation, although this issue is not germane for computing the difference between the WACC and g. For sake of simplicity, I ignore inflation in this discussion.

Analysts routinely assume values for free cash flow growth rates that are higher than the textbook formula. Moreover, these assumptions are buried in the multiples they use. If you do the math, you will discover that JPMorgan’s implicit value of g is 11% per year. The textbook formula indicates that if Tesla is expected to earn its costs of capital exactly, the corresponding value of g would be 8.4%. Using 11% for g when 8.4% is warranted is a bias known as growth opportunities bias.

Using 8.4% will produce an estimate of enterprise value for Tesla that is in the neighborhood of what you get using the simple EBI/WACC formula. Try it.

Tesla’s free cash flows were negative until 2018. Once positive, they grew quickly through 2021. In 2020, they grew at 128.6% and in 2021 at 19.7%. However, in 2022 growth turned negative at -25.5%, and in 2023 it dropped further to -175.9%.

Sentiment

The upshot of the Tesla’s fundamental value being so far below its market price is that Tesla’s price mostly reflects optimistic sentiment. On this point, the JPMorgan report establishes a December 2024 target price for Tesla’s stock of $115, not $100. In this respect, the report’s methodology arrives at $115 by taking a 50-50 combination of its $100 estimate of DCF-based fundamental value and a $130 estimate based on multiples such as price-to-earnings and price-to-sales. The multiples approach captures market-wide sentiment, but not sentiment unique to Tesla.

Behavioral asset pricing theory focuses on the decomposition of market prices into a fundamental component and a sentiment component. The target price approach I favor would place a lower weight on fundamental value computed using the EBI/WACC formula, a higher weight on the multiples approach, and the addition of a component to account for Tesla-specific sentiment.

The Tesla-specific component is important. For years, the JPMorgan analysts have assigned Tesla’s stock a recommendation of Underweight. This was the case in July 2020 when Tesla’s stock was trading at $1,592. At the time, the JPMorgan analysts’ target price was $325, 80% below the market price. Its estimate of fundamental value per share was $295 and its multiple-based counterpart was $356. Remember, 2020 was a time when Tesla’s free cash flow growth was high, and its ROIC had just turned positive. In July 2021, a year, later, Tesla’s stock did not decrease by 80% but increased by 140%, vividly demonstrating the power of sentiment. It is a mistake to think that prices revert to fundamental value quickly, or even move in the right direction.

General Takeaways

Sentiment refers to biased reactions to changing fundamentals. The history of Tesla’s stock illustrates just how important sentiment can be in the short-to-medium terms.

Analysts might serve the investing public better, for all stocks, not just Tesla, by structuring the valuation portions of their reports to decompose target prices into fundamental and sentiment components. In doing so, they could also be transparent about base rates for ROIC and free cash flow growth rates. Specifically, they can exercise caution about giving due weight to base rates and avoiding representativeness bias, in an effort to mitigate growth opportunity bias. Doing so just might lead market prices to more accurately reflect their corresponding fundamental values.