The Valuers Dilemma: Understanding the Tesla Stock Valuation

This morning I watched a fascinating debate on the YouTube channel “Tesla Daily” (https://www.youtube.com/watch?v=C0Fl6JBQgrc) between Rob Maurer and David Trainer. Rob is a self-confessed Tesla Bull, a columnist on The Street who hosts this excellent and influential YouTube Channel. (full disclosure – I am a subscriber and Patreon supporter of his). David is a respected, long time Wall Street analyst, the founder and CEO of New Constructs, an independent financial analyst, and a self-confessed fan of the Tesla car and its founder Elon Musk.  However, in contrast to Rob, David has a very sober view of the current stock price, considering it highly speculative. His firm has authored a note warning that Tesla is “the most dangerous” stock for the investors with fiduciary responsibility.

What struck me as I listened to the debate was that both Rob and David appear to talk past what I consider to be the root cause of the current Tesla stock price, and its probable future value. Elon Musk is famous for insisting on looking at every problem from first principles – and even more famous for being so successful in the application of those principals. Let’s follow Elon’s dictum here to learn why Tesla’s stock has reached such stratospheric levels and evaluate whether it is likely to remain as high or even grow further.

In the matter of the Tesla valuation, I believe the first principle that governs is the Innovators Dilemma, which for brevity we will refer to as InDi. It underpins the entire value proposition represented by Tesla, not just in the gigantic global automotive market, in transportation in general, and perhaps – ultimately even more importantly – in the global energy markets.

InDi is not well understood by the analysts, and is seldom accorded significant value, which is perplexing as it is an extremely well understood process. It was formulated by Clayton M. Christensen while Professor of Business Administration at the Harvard Business School and popularized by him in many writings. Christensen writes:

When disruptive technologies emerge, dominant, well-run companies often stumble. These companies tend to use the same sound business judgment that has guided them through previous changes, including:

  • Listening to what current customers want
  • Providing more and improved versions of what customers want
  • Investing in projects that promise the highest returns

However, in the face of disruptive innovations, these strategies don’t produce the same results. This is the innovator’s dilemma: The approaches that lead to success in adopting most innovations lead to failure when confronting disruptive innovations.

Elucidating on those key finding, Wikipedia adds the following woes to the incumbent’s situation, (each of which readily identifiable with the OEMs!):

  • Small markets struggle to impact an incumbent’s large market
  • Disruptive technologies have fluid futures, as in, it is impossible to know what they will disrupt once matured
  • Incumbent Organizations’ value is more than simply their workers, it includes their processes and core capabilities which drive their efforts
  • Technology supply may not equal market demand. The attributes that make disruptive technologies unattractive in established markets are often the ones that have the greatest value in emerging markets

On the other hand, consider the position of the challenger:

  • They develop the disruptive technology with the ‘right’ customers. Not necessarily their current customer set
  • They place the disruptive technology into an autonomous organization that can be rewarded with small wins and small customer sets
  • They fail early and often to find the correct disruptive technology
  • They allow the disruption organization to utilize all of the company’s resources when needed but are careful to make sure the processes and values were not those of the company

It is easy to recognize the Tesla in these qualities. Finally, Wikipedia points out

  • Disruption is a process, not a product or service, that occurs from the fringe to mainstream
  • Originate in low-end (less demanding customers) or new market (where none existed) footholds
  • New firms don’t catch on with mainstream customers until quality catches up with their standards
  • Success is not a requirement and some business can be disruptive but fail
  • New firm’s business model differs significantly from incumbent

Success, in simple terms, Christensen says, is “correlated with a business model that is unattractive to its competitor”. This is brilliantly true in the case of Tesla vs. OEMs.

A telling example of the business model problem of incumbents becomes apparent in the YouTube debate when Rob Maurer points to the direct sales model of Tesla, capturing the profit margin that would otherwise go to the dealer. David Trainer argues that the dealership network of the OEMs is a strength, allowing the OEMS “concentrate on their main business”, providing them with broad distribution. What eludes him is that this same dealer network becomes uneconomic in an EV world, as the service and spare parts business on EVs are not 10% of that of an ICE vehicle. In simple terms, the dealership can only be run at a loss, and Tesla’s online sales are a significant advantage. Early evidence is that OEMs have been unable to persuade their dealership network to sell EVs, contributing to the woeful sales of legacy OEM sales of their electric vehicles. The dealership network is at the core of the OEM business model that would be legally, culturally and financially impossible to voluntarily sever; yet with it, the OEM EV future is probably doomed.

Another example of the business model problem is the “deep supply chain” mentioned by Trainer as a significant advantage to OEMs. Unfortunately for them, this may be the most serious problem for the OEM business model. It is this supply chain that inhibits the development of a vehicle, with an integrated battery/drivetrain/HVAC/computer system, a vitally necessary step to creating a competitive EV offering (and the reason for the failure of so many “Tesla Killers” to date). The key intellectual property of OEMs retain is their internal combustion engine designs, possibly the only component – apart from the sheet metal – that they develop and manufacture in-house. Ironically this is the technology that is of least value – in fact no value – in this new market.

To compound the problem, the challenge is not just a matter of replacing an internal combustion engine with an electric motor, and simply adding a battery in the stead of a gas tank. Instead it is a highly complex problem of redesigning the drivetrain and vehicle into a single, comprehensive whole. Depending on a supply-chain network to provide this does not permit the iterative design/development necessary to rapidly evolve successful solutions to this very difficult problem. With well evolved, century old technology, depending on supply chains for R&D of everything but the engine made sense: but the situation has changed, and dramatically so; disruption is now occurring. OEMs development cycles traditionally stretch to years. Tesla iterates its designs from month to month to month.

Large OEMs are not given to iterative design/development. This is a longer discussion, and perhaps key in differentiating Tesla from the incumbents. It is sufficient to point to the continuing and growing technological leadership of the company’s vehicles over the incumbents. It is instructive that the industry has not yet been able to manufacture a car to compete with the Tesla Model S, first sold seven year ago.

One could cite many other startlingly clear examples of InDi in the Tesla versus all the others debate. This is also true of Tesla’s work in the energy markets, but I won’t do that here, it is all well documented, and Rob is probably more of an expert than I am in this field. Instead I want to return to the question raised at the outset: the problem of valuation. How does one value stocks of InDi companies, stocks that David Trainer is sure to label, as he has with Tesla, as the “most dangerous” of all stocks.

The answer, of course, is “with great difficulty.” Aswath Damodaran, the “Dean of Valuation”, NYU professor famous for valuation methodology, talks about his struggle – and consistent failure – to value Amazon, that well-known bookseller (http://aswathdamodaran.blogspot.com/2018/04/amazon-glimpses-of-shoeless-joe.html)

Oh yes, of course I know Amazon is not a bookseller. But in the early days we were told – by professors of valuation – that Amazon would have to sell all the books sold in the world to justify its valuation. Amazon taught us several important points. It proved the Christensen principles “Disruptive technologies have fluid futures”, and “Disruption is a process, not a product or service, that occurs from the fringe to mainstream”, and probably a few more besides. What is more important about the Amazon example, is the admission – in the above cited article – made by Damodaran of the extreme importance of this fact:

“Bezos …telling his stockholders that if Amazon built it (revenues), they (the profits and cash flows) would come. In all my years looking at companies, I have never seen a CEO stay so true to a narrative and act as consistently as Amazon has, and it is, in my view, the biggest reason for its market success.”

And further:

“I have consistently under estimated not only the innovative genius of this company, but also its (and its investors’) patience.”

So here we arrive (finally) as my thesis. Like Jeff Bezos, Elon Musk is an innovative genius, who has defined clearly his objectives, methods and objectives. He has created an innovative, rapid learning machine to create products with enormous market appeal and success, in gigantic global markets, and delivered by a highly productive business model. The firm has found its stride in producing and delivering in mass and is in the process of demonstrating its ability to scale. It has built and successfully brought to production in a record time (at several times the speed of the legacy OEMs) a massive factory in China. It is in the process of – simultaneously – building three gigantic factories across the world and is demonstrating a confident touch in those buildouts. And, to top it all off, Tesla is finding ways to drastically reduce costs of manufacture (https://electrek.co/2020/08/25/tesla-start-operations-worlds-largest-casting-machine/).

All Good. Rob aced these points. Here is the miss. Tesla DOES NOT INTEND TO MAKE PROFITS in the foreseeable future. Tesla has said in many fora that is intends to minimize profits. Elon said in the last conference call that the objective to show no more than 1% or so of profits. He, like Jeff Bezos in the quote above, understands that the InDi is focused on market share, not profitability. Tesla is focused on and is on a clear track toward dominance of the Automobile market. And I confidently predict that Tesla’s shareholders, like Amazon’s before them (many of them, after all, are the same people and institutions) will be quite content with that.

Tesla already has a huge price advantage over its competition. Critics – David Trainer amongst them – do not yet realize that Tesla will shortly no longer be a “premium” priced vehicle – Tesla is persistently driving down the price of its vehicles, and their cars are rapidly approaching price parity with Toyota, even while their automotive gross margins are trending higher than the OEMs. Tesla has demonstrated significantly better price/value against their competition.

Why? Because of Wrights Law (The cost of a unit decreases as a function of the cumulative production – https://spectrum.ieee.org/tech-talk/at-work/test-and-measurement/wrights-law-edges-out-moores-law-in-predicting-technology-development) is on Tesla’s side. They have 1 million EVs behind them. No other OEM approaches them, and they will deliver half a million vehicles this year, 5 times more than the nearest competitor, over a million next year, and on and on. VW hope to reach 1.5 million vehicles by 2025. At that point, Tesla are targeting to have delivered over 8 million vehicles (and have plants already built or in building stages) to enable them to deliver those numbers. Tesla’s production cost should be dramatically lower than that of other OEMs. (ARKinvest, a fund manager dedicated to disruptive innovation brought Wright’s Law to my attention – https://ark-invest.com/wrights-law/)

Tesla could translate this advantage into profitability, but the point the point – according to Elon and the company – Tesla won’t. Tesla will drive the cost of the car down inexorably, while at the same time dramatically increasing the efficiency of their capital expenditure (https://cleantechnica.com/2019/10/26/capital-efficiency-teslas-obsession/)

So, throw away your spreadsheets. All those CPAs and valuation specialists carefully compounding profitability and cash flow – its not going to happen. Prices are going to be driven down, free cash is going to be aggressively invested into plant, charging infrastructure, service centers, AI chip development for Autonomy, supercomputers for AI training, Powerwalls, Solar Roof, Autobidder energy trading platform, and on and on. But no profits, and no free cash flow.     

Rob and David both rely on the spreadsheet method and apply a predetermined formula to arrive at a discount of some variation of combination of the profits/cash flow of a firm for a given (presumed) scenario. In this they are joined by the Dean of Valuation, Aswath Damodaran.

But Damodaran should have learned from his Amazon experience. In the case of Amazon, he regrets selling his shares in 2012, and missing the huge run that stock has enjoyed since. But in January of this year he once again applied his spreadsheet formulas, this time to his investment in Tesla, resulting in him sellin his stock at $640. He said:

 “The momentum is strong, and the mood is delirious, implying that Tesla’s stock price could continue to go up. That said, I am not tempted to stay longer, though, because I came to play the investing game, not the trading game, and gauging momentum is not a skill set that I possess. I will miss the excitement of having Tesla in my portfolio, but I have a feeling that this is more a separation than a permanent parting, and that at the right price, Tesla will return to my portfolio in the future.”

In this, I believe he is wrong. I don’t believe this is a “story” stock, nor is it a “momentum” stock. It will certainly fluctuate very widely over time, given the emotions of its supporters and detractors. But, now that Tesla has demonstrated its ability to execute, it is highly unlikely that it will return to the “right price” according to his formulations.

Tesla today, like Amazon in the early 2000s, is a stock that has proven its ability to both innovate at the extreme, and to execute. It truly deserves the Innovators title. It is on a clear path to dominance – not just in the EV market – but in the Auto market, and beyond that in the energy market. What is missing in Rob, David, and Aswath’s calculus, is the formula that values an Innovator that can disrupt large, established markets. We must re-examine the arc of Amazon, Google, Microsoft (in the early Gates years), Apple (in the Jobs years) and the sparse number of firms that have truly demonstrated the characteristics of Innovators. These characteristics are not ephemeral – they take some years to evidence themselves – and they have clear markers. They do not occur frequently, certainly not as frequently as Venture Capital sponsors would have us believe, given the number and rate at which they berth their “Unicorns”. But for legitimate disruptors I believe the appropriate valuation is a function of their Total Addressable Market (TAM). In the case of Amazon it is a function of the retail and technology markets in the geographies in which they operate. In the case of Tesla, it is in the global automotive and energy markets in which they operate.