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this is the video assessing the stock Tesla is part of the weekly series called featured stocks Tesla is the assessment we're going to go through this little could be a little bit different than other ones because of the unique nature of tests on the kind of stock that Tesla really represents so in the closer look that is we briefly looked at this chart here it is talking about how across the Russell 3000 in a typical year the returns are not really normally distributed down the middle of the of the chart it's normal looking but at the extremes you have this fat tail phenomenon where a unusual amount of stocks more than be expected by a normal distribution or return high returns and there's also a abnormal amount of stocks that do extremely bad and have very negative returns you can see here in a study it was done about 36 percent of the stocks are positive in a typical year and 64 percent are actually negative so most of the returns in the marketplace come from only about one third of the stocks now those one-third about 6% of the well not out of that one there about out of the total stocks in the Russell six 3,000 about 6% of them account for the lion's share of the returns in a given year so Tesla represents that kind of a stock for it's it's going to be one or the other it's either gonna be in on the extreme positive return or likely going to be an extreme negative return and just pull unlikely to be much milk round on average over over the next couple of years is a stock like this eventually plays out another view of this kind of stock is this view that was been shown before is that risk return you'd like to think that the higher the return the risk you take the more return that you're going to but any point between the risk and return there's actually a range of possible returns like we showed earlier just in the previous diagram that fat tails mean that even this isn't really that accurate that you can't just go out and buy a bunch of Tesla like stocks and hope that through thought there's some diversification you'll end up with an average high return no with these kind of stocks that have you know that are very high risk typically are very fat tailed in nature so Tesla represents that kind of stock and therefore the assessment that we're going to do is a little bit different because the stocks tend to be very dependent on their stories and the each investor really has a unique story that they've come to in terms of what they think about the stock and what the prospects of the stock are so without getting into all the storytelling and how you could commit yourself one way or another in terms of what a stock might be worth these kind of socks it's best to just immediately go to the slider and for growth and just move it until you don't see the practical valuation changing anymore you can see here for Tesla that happens when you get to a theoretical valuation and a growth of 93 percent a year over year growth and 46 or 406 dollar theoretical value so anything above that doesn't move the practical valuation so as a refresher as to where practical valuation comes from I'm gonna bring this chart that we did discuss in a closer look series on valuation quickly around them value practical valuation but as a reminder practical valuation is is building the first website is kind of a safety net so that regardless of the valuation and this doesn't align with Tesla's sister generics like let's say you have a stock that you're currently valuing 144 dollars it's based on some assessment of rest now represented by beta and also by the total sales growth that your sorta yeah the sales grow through seeing year-over-year the market though at any given time it has a certain price and in this slide it's forty four dollars and fifty two cents for a hypothetical stock and it ends up with quite a disparity between what the market is currently thinking with the price which when you work back through the reverse engineer the formula comes out in this case to be a beta of around 0.9 and a growth of twenty four percent that's quite different than the valuation that's assuming a fifty seven percent growth with the same risk factor so practical valuation as a reminder says well how do we marry the two between or a disparity between such a good story evaluation that goes with that positive story yet the market seems to have a in aggregate a a quite different story that they seem to be thinking and so practical valuation says you can only expect so much movement from the market encourage in terms of their thinking around risk and sales growth so I'm not gonna go through that whole video is just suffice to say there's a limit to how much you can expect the market to change its opinion so regardless of what your own opinion may be the story you come up with if it gets further and further as it moves further and further away from the consensus view you reach a limited we're just pleura says you're not going to be you know realistically practically speaking you just can't really play on the market changing their opinion any more than a certain amount so that's what we're seeing here as we move the slider is yeah the story gets better and better better better but even when we take it all the way to the right you know it still doesn't matter there the market is long ago stopped even considering this kind of sales growth that you consider so this is the first place I always start with a stock like Tesla is this take the slider to the right and this see where you're at a practical investment return stop sad then bring the slider back down to see where you first see that limit hit and in this case it's a sales growth of around a hundred percent so let's go back to the default default is 75% growth that's always the first input values you should think about changing first on now we know by or sliding it all the way to the right kind of with the upper modification we can make before we hit the practical valuation maximum so we only have about a 25% addition to sales growth we can play around with so either we change our opinion about sales growth and take it up to a hund maybe up to a hundred percent or we could change our opinion about some of the other input parameters and modify the sales growth to reflect that change in opinion well let's start off with sales growth first and if we come down here at the bottom we can go off like we do in other like we've done with other future stocks and you go out and see what CNN is showing for forecast for sales growth for Tesla and we come down here we can see here that the analyst that they've included their assessment has a consensus growth of about seventy of seventy two percent per year so that's in line but the sales growth that we're thinking based on not the approach the flourish uses the decree that fall so it's in the ballpark of but the scene inside show so on the surface it seems like a reasonable number to stick with this seventy-five percent year-over-year bro now before I leave that and look at the other input values I also want to talk about for these kind of companies that that we got to consider what we even mean by that kind of growth now the way that the valuation model works and this does reminder here is the valuation formula itself it's just simply the dividends for Y years and then there's a future value that's calculated and discounted back so there's it's a two-step process and so back to this other diagram --is-- not ready to show you is that that we assume it to get to that two staged approach you assume a certain level of growth of sales in the first stage usually five years and then you assume that goes it mean reverts to a more industry standard growth from then on out well when you're talking about these high flyers that are growing it this case with Tesla seventy five percent well what does it drop off to then at the end of five years well the industry standard that could be used you know for the auto industries could be something like 5% sales growth so when you think about your over year sales growth of seventy five and then it drops to five that's conceptually kind of hard to beat your your your head around so a better a more appropriate way to look at these high-flying kind of stocks is that you're really assuming that the growth rate is starting out at a hundred to one hundred and fifty percent when you when you assume seventy five and then it drops down to you know five ten percent whatever it is the industry standard is and the average works out to seventy five percent so if you want to know what you know you're really thinking with these high flyers if this simple formula is this two times the growth rate that you that you've used with the sales growth slider and then subtract off where you think it's going to eventually land now these high flyers that the growth rates are so incredibly high that where you eventually land is so insignificant internment relative value they get almost assumed as zero so that's why I like to say okay a high-flyer anything over about 20 percent growth I'm just going to multiply it by two and say okay it's really assuming I'm starting off at a one hundred fifty percent growth and then I'm gonna end up at the industry average of a five or ten so that makes more sense than thinking that we're just gonna have you know high growth and then boom all sudden just dropped down to an industry standard growth now we're gonna have very high growth in the early years and then we're gonna gradually drop off to the industry standard and you can do that by using an average across that first five years which in this case we're assuming 75 percent so another way to think about sales growth is besides checking against CNN or other sites is if you happen to be keeping them on the news but with a stock like Tesla it's hard not to keep up on the news but here recently they said that they had produced about 80,000 cars during their life they were hoping to get up to a 5,000 a month production can pass or per week sorry per week so that's about 250,000 cars when they bowling burns up to the up to now they've only produced 80,000 so to think that they're going to take production that would that would be almost a three-fold increase in production and that's not even year-over-year this is from the life of the company till next year they're gonna increase threefold well that works out to about 200 percent growth and this using that method I just talked about where we assume that the starting point of the high growth where we start from us is essentially two times the average rate that were assuming that would make it 150 but forever when you figure out future sales it's one plus the growth rate so that's two and a half two hundred fifty percent from where we are now so that's in line with that number from 80,000 cars to 250,000 - think that we'd start right around 150 percent growth and then eventually get down to the 5 or 10% 5 years out so that justifies yet again the 75% is probably a number that's reasonable to go with now sleighing going down and look at the other input values the main ones that come into play when you're dealing with a high flyer like this is profit margin and well it's primarily profit margin so right now we're assuming a 5.3 percent profit margin five years out when a company like Tesla they could be creating a whole new industry where instead of thinking that they're gonna mean revert to an automotive standard profit margin they may end up defining a new profit margin fact o'leary the analyst that appears on CNBC recently was talking about the fact that tesla does not have any engineers currently working on combustion engines their whole company is Duke geared toward electric we compare that to a four to Chrysler there as they introduce electric cars they still have a big infrastructure all around combustible engines so you think well okay just let me have a competitive advantage long term not to have all that legacy investment on combustion engine if they focus just on electric engines they may end up with a higher profit margin so let's go the profit margin let's say of 7% well 7% compared to where they are now that's almost a 40% increase in value so if you watch the other bit you know that in order to get a 40% increase a way to bring that into the assessment here is just a 40% increase in price when it's a 250 that would take it up to you know about $350 so we just move the slider until we see 350 and that's about there now still under the a practical return of twelve point three that we saw so yeah that that's we could stop there with the assessment but to score down look at some of the other input parameters I see that the p/e ratio is a little smaller than I would expect it to be I would think that by the time Tesla gets to be a mature automotive style company that they would have you know a p/e ratio more in line with other automotive companies so it would be more like 14 so that would help with it again another by about another 12 percent so where we are now at 350 they would take it up to about 400 so I want to move the slider to the right till I get to about 400 and now I've hit the maximum I know that no matter how much more I move it to the right I'm not going to get any higher practical investment return there was this if there's anything left that we would want to know the share issue looks reasonable that there got to continue to issue equity that to cover there they're in a growth and then the other the other main one that we would consider would be could their growth go on for for more than just five years but for seven years and that would be a legitimate one that probably increased to seven but it doesn't matter because we've already hit the limit here of twelve point six percent return so with that being the practical limit to what we can expect or what klarissa's kind of guiding us to expect what about the risk that's associated with and if you watch the video on the cost of capital you know that that's always something that should be considered is the last step in and it's anyway you've got a a practical investment return that's really something that's really equitable in terms of the risk that you're being exposed to well you can see historically that the price variance has resulted in a expected market return of 7% that's because typically a high-growth comfort like Tesla their growth their stock price is going to be fairly independent of the overall market movements they just tend to plow forward or drop on their own but we're talking about you know out into the future what would where do we think we want to kind of categorize here risk instead of calculated so what do we feel more comfortable with in terms of thinking with the likely rate of return we should expect for the level of risk that we're seeing around this kind of company well without going a lot a lot of run out of time here I'm not going to go in and go into a lot of detail here but the overall an average stock in the S&P 500 has a market expected rate of return of about 7% and I would put Tesla easily at least double that kind of risk that's associated with a 7% return so I would think the beta would be more like you know double the average in the market and that we should expect more of a you know 1415 percent return and as you know if we were to lower the cost of capital to 14 or 15 percent it would drop the practical valuation below the current market price and that would be a clear signal that the risk associated with this would outweigh the return but if you dis lower your expectation risk assessment to you know twelve twelve point six specifically this would be in line with what you would be willing to go forward with so that's where I'm going to end up on this video was that with some pretty lofty expectations in terms of sales growth in terms of eventual PE and also that they are going to be able to eventually land at a profit margin higher than the automotive industry and the riskiness of doing that seems actually that this is a prospect that yes that risk return although I'm sure people would like to see it maybe the return potential being 20 30 percent but 12.6% seems like with you what the price word is today seems to be what you should expect and the risk associated with that is in line so I say it's definitely a prospect
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