The Inclusion Effect.
A flurry of optimism has surrounded Tesla’s ascension into the SP500 by the 21th of December. Acting as one of the reasons the share has risen so dramatically, on frantic speculation that ample liquidity from passive index-funds will continue to drive the share price higher. Taking a look at research, specifically on the “Inclusion effect”, provides a slightly different and sobering interpretation and the general course equities take after being included into the SP500.
In a comprehensive sample of companies being included into the SP500 between the years of 1993-2000, researchers examined returns associated with a stock’s inclusion into the SP500 index.
What Drives the S&P 500 Inclusion Effect? An Analytical Survey
https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1755-053X.2006.tb00158.x
”Conclusion
We conducted an analytical survey of the various hypotheses that have been proposed to explain the increase in stock value associated with inclusion in the S&P 500 Index. These hypotheses deal with price pressure, downward-sloping demand curves, improved liquidity, improved operating performance, and increased investor awareness.
What Drives the S&P 500 Inclusion Effect?
The most important find in our study is that increased investor awareness is the primary factor that explains the cross-section of abnormal returns associated with inclusion in the Index. The investor awareness hypothesis is an application of Merton’s (1987) theory of capital market equilibrium with incomplete information, under which an increase in investor awareness results in a decline in the stock’s required rate of return.
When we examine all the hypotheses simultaneously, we find no significant relation between the cross-section of abnormal returns and proxies for downward-sloping demand curves, anticipated improvements in operating performance, and improvements in liquidity. However, we do find evidence of temporary price pressure associated with trading on the inclusion date.”.
Conclusively, we can see that the inclusion effect tends to be rather short lived. In the long-run, this is smoothed out and starts reverting to the fundamentals the equity exhibits.
Exuberant market expectations have therefore, pushed the share price higher. Seemingly forgetting that an up-listing to the SP500 does not exclude the share of being governed by fundamentals. However, it is not sufficient to explain the rise of the share price as solely being attributed to the Inclusion Effect.
Political expectations the main driver in recent Tesla gains.
In my view, the dramatic rise of Tesla's share price this year, is primarily attributed to market expectations placing high hopes on a more restrictive political policy on U.S. auto-manufacturers, as a part of broader environmental policy by the Biden-administration, in getting U.S. law aligned with international standards that are getting increasingly restrictive on auto-emissions.
Furthermore, if one takes a top down-view on the largest automobile markets in the world, one clearly sees that after China, U.S. comes second place. Markets are therefore optimistic that the Biden-administration increased efforts to restrict fossil-fuel EVs would drive interest towards the EV-sector, benefiting Tesla in the world’s second largest automobile market.
- Statista.com
If one compares the U.S. and the E.U. in terms of scheduled bans on fossil-fuel vehicles, one clearly sees that the majority of these commitments are primarily originating from European countries.
https://en.wikipedia.org/wiki/Phase-out_of_fossil_fuel_vehicles
Recent news the latest months of countries increasingly placing fixed dates on banning the sale of fossil-fuel vehicles, has only increased excitement in the EV-sector. Similar or equivalent restrictions on fossil-fuels vehicles in the U.S. would only propel further interest and benefit Tesla sales, due to the large size of the U.S. automobile market.
Out of the 50 U.S. states, California has stepped forward lately in scheduling the ban of fossil-fuel vehicles in the year 2035.
California to ban sale of new gasoline-powered passenger vehicles in 2035
https://www.reuters.com/article/autos-california-emissions/california-to-ban-sale-of-new-gasoline-powered-passenger-vehicles-in-2035-idUSL2N2GK1EF
Provided that California is the 7th largest economy in the world on a non-country basis, and the largest U.S. market for Tesla sales, have only compounded the euphoria we have seen the last months in the stock’s ascension higher. While, Tesla sales have fallen due to the SARS-COVID-19 pandemic, the current vaccines developments are likely to place it on track of regaining sales growth in their biggest market.
Tesla third-quarter registrations in California drop 13% - data
https://www.reuters.com/article/tesla-registrations-idUSKBN27509L
Markets are probabilistically, expecting further U.S. states banning the sales of future fossil-fuel vehicles, driving the share higher.
While, these expectations have a logical basis, I believe there is a naivety and overoptimism surrounding this particular type of thinking.
First, politically, there is a substantial power-divide between the House & Senate, with Democrats having a majority in the house and Republicans keeping a majority in the Senate, making it difficult to pass any major overhauling legislation at all - significantly limiting Biden's power. I believe markets haven't factored this in yet in Tesla’s case, and it will be a very sobering wake up call when this manifests fundamentally in a couple of months.
Secondly, the U.S. with its increased market-share on the global arena in the production of petroleum products, faces a dilemma of keeping the oil-producing states in a state of not being to overburdened by regulatory red-tape and thus risking a backlash from increased oil-industry lobbyism in the White House. In all likelihood, these lobbying efforts are probably already happening.
I believe that Biden will have great difficulties in juggling an outward policy of aligning U.S. leglislation towards more environmentally friendliness, whilst also keeping U.S. oil producing states from additional regulatory burden, that would accelerate the demise of the oil-sector that is scheduled to be phased out in decades to come.
There is no incentive for oil-producing states to reduce domestic consumption of oil, as it would be counter to their business incentives on making a profit on oil-production. Increasing fuel-efficiency standards on fossil-fuel motors is therefore not in the oil-industry’s interest.
An equivalent scenario is likely to unfold, which has been in display during the Trump-administration, with some states imposing stricter emissions standards than comparable federal legislation, as individual states consider federal legislation being too lenient, and not extensive enough in its wording on reducing automotive emissions.
Eventually, individual states will recognize Biden's meagre attempts on increasing fuel-efficiency standards. While, it is likely and realistic to expect proposals on increasing fuel -efficiency and similar environmentally friendly legislation being adopted. These bills will be significantly watered down due to the limitation of Biden’s power and the minority power the Democratic party has in congress – which both are the primary drivers in focusing on environmentally policy in U.S. politics.
If this happens, you can expect a temporary albeit severe decline in Tesla's share price. Option markets are currently displaying an IV of 66% for Tesla in the next 6-12 months. That puts the stock’s range between, calculated from today's price - 669$, between 207 to 1130$.
Is a 1130$ share-price realistic, if you compare Tesla's market capitalization with other globally established car-manufacturers?
Let us dissect Tesla and analyse its history to see if there is any merit to such an evaluation.
Tesla’s strength in technological know-how.
Tesla has the technological know-how and accumulated experience of almost a decade in producing purely EV-vehicles. I would attribute it to Tesla almost having a monopoly in the production of EV-vehicles. Significant first-mover advantages exist, and brand-recognition with its luxurious and appealing design is almost akin to what Apple enjoyed in the early 2010s and onwards to this day. Tesla’s strong brand-recognition is not scheduled to end anytime soon.
No car-manufacturer is close to the production capabilities Tesla has when it comes to EV-vehicles, nor possesses the sophisticated technological know-how. It has also started slashing prices which would make it more affordable to consumers from lower income-demographics.
Tesla cuts prices of Model S in United States, China
https://www.reuters.com/article/tesla-model-s-idUSKBN26Y1CF
It is also important to take a topdown-view of where we're headed the next decade.
5G is set to completely alter the way of life. Teslas self-driving technology, heavy investing in AI, is going to be a part of this development. Tesla and its driving technology differs in numerous ways of the paths competitors have chosen.
While the majority of car-manufacturers have opted on using LIDAR-technology, Tesla has opted on developing a different path in their autonomous driving technology, aiming to not rely on 5G and use FSD-technology instead. While, this technology is still in its infancy, its leverage lies in that the driving ability is set self-improve based on recursive improvement of the existing car-fleet of 1 million cars and their continuous feed of driving-data. Tesla’s two new factories and future ramped up production is set to only increase the car-fleet and the amount of data-sets utilized in the training of autonomous driving algorithms, further improving autonomous capabilities.
”Interestingly, Musk explained that FSD will work like Google's search: It will get better the more it's used.
"Having on the order of 1 million cars that are providing feedback and specifically feedback on strange corner case situations that you just can't even come up with in simulation" will help to improve the system, Musk said on Tesla's earnings call. (Tesla inked a deal with AT&T in 2014 to connect its cars to the Internet.) "This is the thing that is really valuable."”
- https://www.lightreading.com/aiautomation/teslas-5g-stop-sign-self-driving-needs-no-connectivity-whatsoever/a/d-id/764855
Tesla’s different path and focus on FSD, is set to potentially provide them with a competitive advantage as well as complement on not solely relying on LIDAR-technology and 5G. Geographies, that do not have sufficient 5G coverage could therefore still render operational autonomous driving by Tesla cars.
Realistically, FSD is probably not solely going to be used in Tesla’s, but rather a combination in the future of 5G+FSD, if trouble were to arise in the development and reliance on FSD alone.
Competitors are likely to leverage the unique benefits provided by 5G and LIDAR in combination, and training on datasets, but the distinguishing factor is the historical emphasis Tesla has invested heavily from an early start in developing autonomous driving. Integrating software in the car, transmitting driving-data, to centralized databases storing information on performance metrics during the lifespan of the car, provides them with unprecedented and precise data for future improvement of driving abilities. Therefore, the aforementioned competitive advantage lies in the first-mover advantage and amassed technological know-how Tesla has.
Tesla is starting to resemble a software company than a pure car-manufacturer.
A development that is set to permeate the entire car-manufacturing sector as a whole the coming decade, due to increased interconnectivity between cars and the 5G network.
Risks still exist despite these technological leaps. Different regulatory landscapes across jurisdictions could significantly hamper the roll-out of fully self-autonomous level 5-driving. If this proves to be significant, there would only be a very small subset of jurisdictions allowing autonomous-driving, severely dampening prospects of adding additional revenue.
Tesla 'very close' to level 5 autonomous driving technology, Musk says
https://www.reuters.com/article/us-tesla-autonomous-idUSKBN24A0HE
Part of the current valuation surrounding Tesla is therefore based on future expectations that are likely to unfold in the car-manufacturing sector as a whole due to 5G-rollout the next years, and its technological know-how leadership position placing it at the forefront from a competitive standpoint in such a rollout. Market expectations and the current runup to the current share-price have therefore partly been based on the overwhelming changes the entire car-manufacturing as a whole is about to experience.
Additional euphoria in the stock is explained by its R&D into solar-power, as of today these represent small and insignificant revenue in comparison from the car-manufacturing Tesla engages in. While, exciting developments are unfolding in the battery-technology space, markets are placing an undue amount of optimism into this sector as it isn’t fully matured yet.
Tesla has thus successfully leveraged its image as being a pioneering company, and developing a product-line of environmentally friendly cars and clean-harvesting the sun’s beams. While, this is amicable, and I do not dispute these endeavors in any way, my main concern lies in that this influences the valuation of the stock to extraordinary proportions.
In essence, a lot of future expectations are being priced in, with the, perhaps, main focal point lying in the increased production levels due to the construction of a factory in Germany and China. If one were to take a quick-glance at current analyst-estimates, one would see the clear and explosive growth priced in.
While these numbers reflect the fundamentally evolving position of Tesla and its increased future sales, the share price is disconnected from its current valuation. Please take note of the increased average analyst rating from 2.94 to 3.27. It happened shortly after the date California announced the ban of fossil-fuel vehicles (23th of September, Reuters article higher up*). Therefore, the restrictive policy argument is indeed fueling a rise in the share price and subsequent revised bullish analyst sentiment in the average rating of the stock. Tesla did not release any press-releases until the 3rd of October, that would of materially affect the stock price at the time, offering a glimpse on deliveries and additionally scheduled dates of the released Q3-report l
Tesla’s released Q3 report of 2020 was released the 23th of October.
DCF
I took the liberty of utilising the in-built DCF-analysis tool by Simply Wall Street, in order to see what the fair-value is. Tesla is covered by 63 analysts. 30 of those analysts submitted the estimates of revenue or earnings used as inputs to this DCF.
Below are the data sources, inputs and calculation used to determine the intrinsic value for Tesla.
| Data Point | Source | Value |
|---|---|---|
| Valuation Model | 2 Stage Free Cash Flow to Equity | |
| Levered Free Cash Flow | Average of 30 Analyst Estimates (S&P Global) | See below |
| Discount Rate (Cost of Equity) | See below | 10.6% |
| Perpetual Growth Rate | 5-Year Average of US Long-Term Govt Bond Rate | 2.0% |
An important part of a discounted cash flow is the discount rate, below we explain how it has been calculated.
| Data Point | Calculation/ Source | Result |
|---|---|---|
| Risk-Free Rate | 5-Year Average of US Long-Term Govt Bond Rate | 2.0% |
| Equity Risk Premium | S&P Global | 5.2% |
| Auto Unlevered Beta | Simply Wall St/ S&P Global | 1.92 |
| Re-levered Beta |
= 0.33 + [(0.66 * Unlevered beta) * (1 + (1 - tax rate) (Debt/Market Equity))] = 0.33 + [(0.66 * 1.917) * (1 + (1 - 21.0%) (2.42%))] |
1.639 |
| Levered Beta |
Levered Beta limited to 0.8 to 2.0 (practical range for a stable firm) |
1.639 |
| Discount Rate/ Cost of Equity |
= Cost of Equity = Risk Free Rate + (Levered Beta * Equity Risk Premium) = 2.04% + (1.639 * 5.23%) |
10.61% |
Discounted Cash Flow Calculation for NasdaqGS:TSLA using 2 Stage Free Cash Flow to Equity
The calculations below outline how an intrinsic value for Tesla is arrived at by discounting future cash flows to their present value using the 2 stage method. We use analyst's estimates of cash flows going forward 10 years for the 1st stage, the 2nd stage assumes the company grows at a stable rate into perpetuity.
| Levered FCF (USD, Millions) | Source |
Present Value Discounted (@ 10.61%) |
|
|---|---|---|---|
| 2021 | 2,704.72 | Analyst x11 | 2,445.22 |
| 2022 | 4,240.01 | Analyst x8 | 3,465.44 |
| 2023 | 5,851.93 | Analyst x4 | 4,324 |
| 2024 | 8,575.13 | Analyst x3 | 5,728.26 |
| 2025 | 10,707.92 | Est @ 24.87% | 6,466.71 |
| 2026 | 12,637.73 | Est @ 18.02% | 6,899.9 |
| 2027 | 14,309.39 | Est @ 13.23% | 7,063.02 |
| 2028 | 15,721.92 | Est @ 9.87% | 7,015.69 |
| 2029 | 16,904.51 | Est @ 7.52% | 6,819.66 |
| 2030 | 17,898.04 | Est @ 5.88% | 6,527.72 |
| Present value of next 10 years cash flows | $56,755 | ||
| Calculation | Result | |
|---|---|---|
| Terminal Value |
FCF2030 × (1 + g) ÷ (Discount Rate – g) = $17,898.043 x (1 + 2.04%) ÷ (10.61% - 2.04% ) |
$213,042.42 |
| Present Value of Terminal Value |
= Terminal Value ÷ (1 + r)10 $213,042 ÷ (1 + 10.61%)10 |
$77,700.2 |
| Calculation | Result | |
|---|---|---|
| Total Equity Value |
= Present value of next 10 years cash flows + Terminal Value = $56,755 + $77,700 |
$134,455.2 |
|
Equity Value per Share (USD) |
= Total value / Shares Outstanding = $134,455 / 948 |
$141.85 |
The DCF-seems to penetrate and shatter the current valuations of where the stock is trading, and I assume even if one were to be 3x times as bullish the value would be at 423$. - 37% from current valuations.
Moreover, the dramatic rise in Tesla's share price has been attributed to a significant short-squeeze, forcing institutions to short-cover their positions driving prices higher in 2020. In all likelihood, the short interest is approaching such low levels compared to historical highs of almost 25% that this amplification in price is set to become negligible in the future. Therefore, prices will rise less dramatically than previously seen.
Conclusion
Markets placed an undue amount of optimism on Tesla’s “Inclusion effect”, which made it a part of the SP500 on the 21th of December. It is highly likely that a sobering reality will set in as the expectations of passive-index funds propelling the stock continuously higher are unlikely to manifest, as the stock is set to revert to trading on fundamentals. In addition to continually declining short-interest, that is set to slow the share's ascent higher.
Furthermore, the political expectations priced in by a Biden administration win, and increased automotive-emission restrictions caused by a more environmentally friendly political policy is also probabilistically set to disappoint current market expectations. The Biden administration’s political powers are set to be limited due to only having majority in the House of Representatives and not having majority in the Republican controlled Senate.
Therefore, stricter environmentally policies are unlikely to manifest in the car-sector, at least as not as strict as currently expected. In extension this would limit current projected Tesla sales.
In addition, I believe that markets are, in part, pricing Tesla and its sophisticated technological potential as a concrete fact, that is going to revolutionize and increase the diversification of their existing revenue segments.
Furthermore, the advances in battery and solar-power that Tesla is developing are not mature enough to fully materialize in additional revenue. Currently, they make up a fraction of total revenues, and in my opinion are scheduled to stay that way for the foreseeable future. Left is a car-company with technology that is alluring and futuristic, but not grounded in current market realities.
Markets are pricing in explosive growth due to two new factories being built in Germany & China, and a lot of optimism on changing U.S. legislation due to an impending change in administration. In my opinion, the stock is over-valued and likely to experience a severe decline that is set to occur after the share has been added to the SP500, and experience significant downward volatility if uncertainty surrounding the U.S. election occurs, especially if
Analyzing the market-cap of Tesla in comparison with other car-manufacturers, would easily place it at 300b $ and not at current evaluations of 627b$. A correction from 670$ to 300$ would therefore be likely in the near future, as this is still at 2x the fair value of the DCF in order to make room for stock euphoria.