The price of Tesla (TSLA, Financial) stock has been on a downward spiral in 2022. Some of the hard-core Tesla bulls might insist this is purely due to inflation and rising interest rates, or the general stock market downturn, but the truth is that the stock was ridiculously overvalued near its all-time highs.
At one point, based on GuruFocus’ reverse discounted cash flow calculator, Tesla’s stock price was so high that it would have needed to grow its earnings per share by at least 70% per year for the next decade in order to be worth the price tag!
However, shares of Tesla have lost approximately half of their value from all-time highs, even as the underlying company has continued growing. The stock has lost its sparkle due to a combination of the negative economic outlook and investors’ realization that Tesla is not the only company capable of producing and selling electric vehicles.
While Tesla may have fallen back into value territory by some estimates, that doesn’t necessarily mean an upwards correction is imminent. For now, the economy is working against it, and some of the factors that once catapulted Tesla’s valuation are gone.
Tesla is now undervalued based on bullish estimates
Based on the GuruFocus reverse discounted cash flow calculator as of this writing, Tesla will need to increase its earnings per share at an average clip of 32.73% per year for the next decade in order to be worth the current share price of $207.40.
While analyst consensus estimates from Morningstar (MORN, Financial) call for a three-to-five-year earnings per share growth rate of 22.16%, that is just an average; several analysts who are bullish on the stock believe it can grow even faster, especially once the company starts scaling up its non-EV businesses such as solar energy and the Optimus humanoid robot.
According to Tesla bulls, the market is failing to take into account how many EVs the company will produce once the EV industry scales up, eyeing CEO Elon Musk’s target of someday producing 20 million vehicles per year. Tesla itself has said that it expects its average annual EV deliveries to grow at a rate of 50% over a multi-year horizon.
The company also continues ramping up production of its solar energy and battery storage systems, and it has high hopes for its Optimus humanoid robot, which it aims to mass-produce cheaper than a car for assistance with basic chores.
Economic signals are mixed for the EV maker
Going off of history, we would normally expect a worsening global economic situation to result in reduced automobile sales. On the other hand, governments are investing more in clean energy to help speed up the energy transition, which is helping to keep demand for EVs going strong.
In particular, many governments are offering tax credits for buying an EV instead of a traditional gas-powered vehicle. Under the Inflation Reduction Act in the U.S., for example, Tesla buyers will qualify for a $7,500 tax credit on their purchase beginning in 2023.
However, Tesla’s economic troubles are not limited to how many consumers are wanting to buy and can afford to buy new EVs. The company is also having to deal with the rapidly rising costs of essential battery materials, and unless it wants to scare off customers by rapidly jacking up prices, it will have to continue eating some of these costs.
Tesla is losing its sparkle
A big component of growth stock valuations is expectations for future growth, which are calculated through a combination of earnings and revenue growth projections, inflation rates and interest rates. In general, growth stocks suffer when inflation is high because this applies a greater discount rate to future earnings. Meanwhile, high interest rates can lower the fair value of companies that have high levels of debt and/or unfavorable debt structures.
However, what most analysts typically fail to consider is that all growth stocks lose their sparkle over time, causing them to naturally see their valuation multiples drop regardless of growth and the general market situation. This is true even when it comes to companies that continue growing at rapid rates in the long-term.
For example, Alphabet (GOOG, Financial)(GOOGL, Financial) has a price-earnings ratio of just 18 despite sporting a three-year earnings per share growth rate of 36%. It’s been decades since Apple (AAPL) had a price-earnings ratio over 50. I expect a similar trend to evolve with Tesla; even if the stock resumes its upwards journey in the future, I don’t think it’s likely that triple-digit price-earnings ratios will return, much less the quadruple-digit ratios seen in the beginning of 2021.
Aside from age, other factors that can hasten the public’s falling out of love with a growth stock include the introduction of serious competitors and (in some cases) diversification.
Takeaway
Amid a mixed economic outlook that is mostly skewed towards the negative side, investors who are bullish on Tesla may see the stock as finally having fallen back into value territory. In order to be worth its current valuation, the company needs to grow its earnings more than 32% per year for the next decade, which won’t be easy but certainly isn’t unheard of.
However, while the economic situation will eventually improve, and Tesla’s growth outlook is strong even in the bear case, growth stocks naturally see their valuation multiples drop over time, in part because it is harder to maintain growth rates off of a larger earnings base and in part because they are no longer a novelty to the market. If we factor in a long-term compression of valuation multiples, not even the bull case makes the stock look too undervalued.
