Tesla—love the car!—but the stock?

New York-based RBC Capital Markets managing director Joseph Spak says automobile manufacturing stock Tesla Inc.’s future free cash flow doesn’t justify its current multiple.

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The insatiable investor demand for clean vehicles produces a very low cost of capital available for both growth and a higher multiple for Tesla shares.

Tesla Inc. (NASDAQ—TSLA) as a company has undeniably changed the auto industry. Tesla has also established a compelling and desired brand, enhanced by the halo of Elon Musk as its leader.

But New York-based RBC Capital Markets analyst Joseph Spak is careful to highlight in his “under-perform” note that this point should not be taken lightly by traditional automakers. The consumer perception of Tesla being a superior vehicle could lead to share gains and higher margins (via premium pricing), and then to continued reinvestment.

Low cost of capital could fund growth

Singing further praises, Mr. Spak says, “Tesla has become one of the most important stocks in the US markets and is the ninth-largest company by market cap. We underestimated a critical valuation point: seemingly insatiable investor demand for alternative and clean vehicles. This manifests in a very low cost of capital, which can fund growth and allow for a higher multiple.

“That being said, we struggle to explain the run-up to the stock split which academically doesn’t change the value of Tesla equity but could help fuel retail investor interest. We still view Tesla as fundamentally overvalued and having to grow into its valuation.

Can Tesla be a FAANG stock?

“We still believe that ultimately a company’s value is related to the present value of future free cash flow (FCF). When we look at Tesla in our simple two-stage model to try to understand embedded expectations (using a seven per cent discount rate, four per cent terminal growth rate) to justify current levels (never mind future appreciation), Tesla would need to grow FCF at an approximately 36 per cent compound annual growth rate for 10 years.

“Our screen of companies that started with $1 billion in FCF and were able to grow FCF at a more than 30 per cent 10-year compounded annual growth rate is a list of three: Apple, Amazon and Alphabet [Google]. We believe it will be harder for Tesla to achieve this given they are a manufacturer that operates in a more cyclical industry.”

This is an edited version of an article that was originally published for subscribers in the October 2, 2020, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.

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