Nine Observations About Tesla’s Crazy Ride

It’s been a crazy year for shares of Tesla Inc. (TSLA), and we’re only in the first week of February. The stock closed at $418.33 on December 31, 2019. It closed at $887.06 on Tuesday before pulling back to $734.70 on Wednesday and rebounding to $748.96 today. These are not typos.

Long-time readers know I mostly refrain from writing about a single stock in this weekly commentary. I’m making an exception this week. The extraordinary volatility in a stock the size of Tesla (its market capitalization was $159.9 billion as of yesterday’s close) provides an opportunity to share some insights about investing and analyzing a high-growth stock.

Here are nine of my thoughts and observations:

1. Be honest about the limits of your knowledge. What’s behind the big moves in Tesla stock? There have been better-than-expected earnings, news about increased production in China, bullish comments from analysts and positively revised earnings estimates. A fear of missing out (aka, FOMO) is likely playing a role as is the vast amount of media attention the stock and the company receive. How certain are you about the exact reasons and your ability to predict how long they will last? Be honest with yourself in answering these questions.

2. Shorting a stock is very risky. Short selling involves borrowing shares to sell with the hopes of buying back the same number of shares at a lower price in the future to pay back the loan. Short selling always comes with limited gains (a stock can only fall to $0) and unlimited losses (at least until an investor goes broke trying to make their margin calls). Tesla had a high short interest ratio prior to its recent run. It is reasonable to believe part of the big jump in price was attributable to short sellers being forced to close their positions.

3. Know the difference between speculation and investing. Tesla’s price moves reflect unbridled speculation. Those participating in the big run-up are hoping to pass along the hot potato before their hands get burnt. It’s the greater fool theory in action. Sooner or later there won’t be enough people willing to pay a higher price, resulting in big losses for those who bought in too late. Those who think they’ll make a profit if the stock suddenly reverses course and/or continues to experience massive price swings are also speculating and not investing.

4. Recognize the difference between luck and skill. Too often outcomes—both good and bad—are viewed as being the result of a process or skill when in reality they are attributable to luck. If you bought shares of Tesla late last year, be both grateful and cognizant of your very good luck. Treat it as such and realize that luck is often fleeting.

5. Ask how many units sold the market cap implies. One way to do a sanity check on a stock is simply to ask: How many units sold does the market capitalization imply? It can be a product, subscribers, licensees or something similar. The numbers don’t have to be exact; you’re simply looking for a decent gauge. In the case of Tesla, the company delivered 112,095 vehicles and reported automotive sales of $6.143 billion during its recently completed fourth quarter. This equates to an average selling price (ASP) of approximately $55,000. Automotive sales accounted for 83% of revenues. If we back down these numbers a little bit to an ASP of $50,000 to account for the Model 3 and higher revenues from energy generation and services, the current market cap implies the annual sale of approximately 2.56 million cars per share based on a price-to-sales ratio of 1.0 (which is the average for the automotive industry). Tesla’s guidance for 2020 calls for 500,000 vehicle deliveries—a big difference. You can certainly tweak the numbers and/or the price-to-sales ratio to do the analysis as long as you remain focused on answering this straightforward question: Is the number of vehicles sold implied by the current market cap reasonable?

6. Consider how much optimism the valuation already reflects. Another simple way to see if the price is reasonable is to look at the valuation. The goal is to determine how much optimism about the company’s future growth is priced in. Tesla traded at 52.2 times projected 2021 earnings and 36 times projected 2022 earnings as of Wednesday’s close. These valuations rank in the approximate top 10% of all stocks. They also are based on the company’s earnings being 1.6 times higher in 2022 from the already strong growth projected for 2020.

7. What about the competition? During the Super Bowl, Audi, Ford, General Motors and Porsche advertised electronic vehicles. Other car companies are offering or are in the process of introducing new electric cars. Ask how much of this competitive threat is being priced into the stock.

8. How certain are you that this time is different? We’ve seen similar stories play out before. Various companies—often emergent ones—generated buzz for a period of time and saw their stocks priced with high valuations as a result. Most are either long forgotten or are mere fractions of their former selves. While Amazon.com Inc. (AMZN) is often touted now as a company that showed how valuations don’t matter to high-growth stocks, it is the exception and not the norm. If you’re optimistic about Tesla’s future, write down your reasons why. Then set up a process for determining if your expectations are being met.

9. There are behavioral factors at play. There have been many papers published about lottery stocks. These are highly risky stocks purchased by investors in hopes of realizing a big payoff. At the same time, there is FOMO and overconfidence from those who think they’ll know when to get out. We’re seeing both at play with Tesla. Speculating on what a stock will do is hard; speculating on what others are intending to do with the stock is even harder.

This week’s commentary is not intended to be a recommendation about what you should do with Tesla. Rather, it’s a framework for stepping back from the noise and rationally thinking through key points about the stock and other highly valued growth stocks. Too often, the chatter about a stock is focused on price instead of the factors influencing/having the potential to influence the price. It’s not always easy, but separating yourself from the crowd and giving thought to key points can increase your odds of investing success.