By: Shaan Bharwani
Elon Musk’s Tesla has stumped value investors and just about everyone else that felt they had any sort of understanding of the stock market. Ticker $TSLA has had unprecedented gains over the past year; “Tesla’s shares have risen more than 420% since the beginning of this year” (Reuters, 2020). These huge moves by the automotive company have left many investors speculating the sustainability of a previously secure method of stock picking: value investing.
What is value investing?
Value investing is a long term strategy that involves analyzing stocks to determine if they are undervalued by the market in comparison to where they should be. Conceptually, value investing is very similar to buying items such as clothes or shoes when you see they’re on sale. The primary difference, though, is that these stock sales aren’t advertised or overly obvious, especially to newer investors. It requires forms of fundamental analysis to pick out which stocks are invisibly “on-sale”. These forms include studying the Price-to-book and the Price-to-earnings ratios of companies. Price-to-book (P/B) is the comparison of the total stock value of the company to the net assets owned. To find the total stock value, the current stock price is multiplied by the number of outstanding shares, and calculating the net assets is as simple as adding up a company’s total assets and subtracting total liabilities. Price-to-earning (P/E) ratios are more frequently used and are simpler to understand as they are automatically calculated by every stock trading website. The P/E ratio of a company is determined by the price an investor is willing to pay to earn $1 profit from the company. Essentially, it’s how much a stock costs to buy compared to how much the company makes per share. When a P/B or P/E ratio is determined to be too low, below 1.0 or 13 respectively, it is dubbed “on-sale” by value investor standards. These two methods are the primary determinants used by value investors to carefully pick their undervalued stocks with high hopes that they will climb up the market over time. Value investing is inversely applicable to overvalued stocks as well. The principle concludes that these overvalued stocks will eventually be reduced to the price that they should be at and are not sustainable stocks to be invested in. These unfavorable stocks are also identified using the same methods as finding undervalued stocks.
What does Tesla have to do with this?
Tesla has been making headlines for the past 6 months with its unparalleled growth following the temporary drop in March. The company has had an astounding run in terms of its market cap with billionaire investor Ron Baron speculating that “Tesla has the potential to hit at least 1 trillion” over the next decade (CNBC, 2020). Even then, all we see so far is that Tesla is a high-performance company that’s having a great year. Value investors presume differently. According to the Royal Bank of Canada, analysts “struggle to explain [Tesla’s] run up to the stock split” due to a lack of growth to spur the massive shift in pricing (Business Insider, 2020). Referring back to value investing analysis, Tesla’s P/B ratio is 42.34. To put this into perspective, 5.0 is considered a high P/B ratio. This ratio dictates that Tesla’s stock is worth 42.34 times as much as its net assets. This itself should be an indicator of how overvalued Tesla is, but the P/E ratio is a final nail in the coffin. A strong P/E for a company is 13–15 which indicates that its stock is trading for 13–15x the company’s earnings. In comparison, at the time of this publication, Tesla has a P/E ratio of 1,083.74. One thousand eighty-three point seventy-four. This automotive giant’s stock is worth over 1,000 times its earnings. But where is the connection between these numbers and value investing? Put bluntly, value investors’ tactics failed miserably when it came to measuring the success of the green automotive company. According to its income statement, the company’s revenue this fiscal year has been $25 billion. For a company worth $390 billion, those profits are a small percentage of what they should be in order to be proportional to the stock price. Value investors have described Tesla as uninvestable due to its volatile nature and its inability to abide by any sort of rules implemented by these investors over decades of practice. Tesla shook the game with its hyper-loyal consumer base and unorthodox growth trends. Whether this trend will continue is up for contention, but what we know for sure is that value investing is not as secure or universal as it was once believed to be. The rules are avoidable, and Tesla is a prime example.
So is Tesla an outlier?
To determine whether or not Tesla’s immense growth is an outlier, one needs to identify the cause behind the scenario. Realistically, this may be attributed directly to Elon Musk and his personality on Twitter. Elon Musk has a following of 40 million people and frequently interacts with them directly or does so through actively posting memes. This has generated a quasi cult following of young investors who idolize Musk and subsequently his company. Evidence of this can be seen with Musk tweeting “Tesla stock price is too high imo” and Tesla stocks plummeting over 10% in May of this year. Musk’s sheer influence over such a massive stake in his company has moved mountains in terms of the success of Tesla. Value investing has relied so heavily on strictly the numbers and has been a strategy since before the age of social media that it does not account at all for the overwhelming influence of pop culture on every aspect of every field including the stock market. So is Tesla an outlier that bends the rules of value investments? Yes, but also no. Yes, Tesla is currently an outlier in the present field of S&P 500 Companies, but it won’t be the only one as more CEOs begin to make their presence visible online and garner a following of younger investors who support them directly.
Value investing has been proven to not be the ironclad strategy that it used to be. It is still a solid strategy but the market is changing for better or for worse and strategies will change with it. Tesla is a groundbreaking stock through and through. The products are not going away anytime soon and neither is the excess hype. The only certainty of the future of value investing and any other stock-picking strategy is that there is no way to determine certainty. Tesla and similar stocks’ futures can only be predicted through educated speculation.