"Tesla. A Much Needed Reality Check (in depth)" - Julian Cox's Expert Analysis Posted

[FluxCap]

I have been around this since 2008. I was a Roadster buyer. He was thanking us for buying that to fund the Model S. So perhaps I am a bit more immune to the Elon Musk charm. Elon is not above basic cash flow and capital costs. I am just repeating myself so I won't bother typing it all out again. Time will tell. But don't be shocked if they need to raise more cash. Just my opinion.

I actually agree with Palpatine here -- I too will be shocked if they don't need to raise more cash before GenIII launch. But I would really, REALLY love to be shocked in that way, and I don't find it impossible. I think Julian has done an admirable job building the model of the first 100% cashflow-funded automotive manufacturing company in history. I dare to believe this is possible -- but I still will be shocked if and when it is pulled off.

- - - Updated - - -

Julian Cox and yourself have conflated the need to raise capital with the cost of capital. They are not the same thing. A zero percent cost of equity means that you would buy Tesla shares with an expectation of earning 0% on that investment in the future (IE giving your money away, and earning less than you could on a riskless Treasury bond). Since the current price of Tesla is close to Julian's 0% cost of capital modelling on Damodaran's website, it is implied that the current stock price reflects a future return of 0%.

No, I have not. There are *many ways* in which the cost of capital and concordant discount rates affect the bottom line of Tesla Motors going forward. What Julian did was zero out this number *in the specific portion of Damodaran's model related to future capital financing* because IN THAT MODEL this is how it is constructed. Mr. Damodaran's valuation spreadsheet does not project a complete 5-year pro forma financials model (something more like this) unless I'm missing something so it is difficult to quickly gain visibility into the calculations, and changing the cost of capital to zero has the effect of zeroing out future fundraising calculations without going through every cell of the model. Which is why Julian did it, for illustrative purposes.

Neither he nor I are conflating the cost of retained earnings and subsequent return on investment metrics for shareholders with future costs of borrowing or raising capital through equity. I think that's what you're doing.

 

[Julian Cox]

Hm. So you're predicting Model S will no longer be production constrained sometime in 2014?

One thing I know is that the guy with the NASA contract said on the Q1 earnings call: "We will test the ceiling of demand in 2014". What I would predict is that saturating all the territories they have opened up this year plus adding RHD cars from March (UK, South Africa, Japan, Australia, Hong Kong, New Zealand etc) it would be one heck of a lot more cars than the typically mooted 40,000 required to outstrip demand. It looks like the battery supply bottleneck that could have contained Tesla to 40,000 is clearing or cleared so we will have to see if we get a change of guidance on that number.

The other thing I know is that Tesla is expanding geographically much faster than would be predictable in the light of an annual supply constraint of 40,000 units so something's going on that does not add up neatly. My hunch is that guidance on 2014 production numbers has been cautious while sorting out cell supply volume commitments.

- - - Updated - - -

Julian Cox and yourself have conflated the need to raise capital with the cost of capital. They are not the same thing. A zero percent cost of equity means that you would buy Tesla shares with an expectation of earning 0% on that investment in the future (IE giving your money away, and earning less than you could on a riskless Treasury bond). Since the current price of Tesla is close to Julian's 0% cost of capital modelling on Damodaran's website, it is implied that the current stock price reflects a future return of 0%.

No, I am not doing that. I appreciate the phrase cost of capital is often applied (as you say) to the opportunity cost of investing, but that is not how either I nor Damodaran have used the term. The term cost of capital when viewed from the investee's angle (the business) describes the costs associated with buying money, not the opportunity cost of investing it. FluxCap has given a perfect explanation.

 

[tumbledog]

No, I have not. There are *many ways* in which the cost of capital and concordant discount rates affect the bottom line of Tesla Motors going forward. What Julian did was zero out this number *in the specific portion of Damodaran's model related to future capital financing* because IN THAT MODEL this is how it is constructed. Mr. Damodaran's valuation spreadsheet does not project a complete 5-year pro forma financials model (something more like this) unless I'm missing something so it is difficult to quickly gain visibility into the calculations, and changing the cost of capital to zero has the effect of zeroing out future fundraising calculations without going through every cell of the model. Which is why Julian did it, for illustrative purposes. Neither he nor I are conflating the cost of retained earnings and subsequent return on investment metrics for shareholders with future costs of borrowing or raising capital through equity. I think that's what you're doing.

You do not understand the mechanics of value. Being free cash flow positive does not take the cost of capital to zero. Ever. I can prove this easily; would you buy a perpetual Tesla bond at par with a 0% coupon?

 

[tumbledog]

One thing I know is that the guy with the NASA contract said on the Q1 earnings call: "We will test the ceiling of demand in 2014". What I would predict is that saturating all the territories they have opened up this year plus adding RHD cars from March (UK, South Africa, Japan, Australia, Hong Kong, New Zealand etc) it would be one heck of a lot more cars than the typically mooted 40,000 required to outstrip demand. It looks like the battery supply bottleneck that could have contained Tesla to 40,000 is clearing or cleared so we will have to see if we get a change of guidance on that number. The other thing I know is that Tesla is expanding geographically much faster than would be predictable in the light of an annual supply constraint of 40,000 units so something's going on that does not add up neatly. My hunch is that guidance on 2014 production numbers has been cautious while sorting out cell supply volume commitments. - - - Updated - - - No, I am not doing that. I appreciate the phrase cost of capital is often applied (as you say) to the opportunity cost of investing, but that is not how either I nor Damodaran have used the term. The term cost of capital when viewed from the investee's angle (the business) describes the costs associated with buying money, not the opportunity cost of investing it. FluxCap has given a perfect explanation.

"The effect on valuation: Simply correcting the cost of capital in Prof. Damodoran’s spreadsheet to 0% in 2014 (the correct figure that corresponds to guidance to growth on internally generated cash from sales) produces a valuation of $200.56. This is before correcting additional clear errors of assumption." Your statement implies that you do not understand what the cost of capital is. The cost of capital will never, ever, ever be zero. Ever.

 

[sleepyhead]

Not So Expert Analysis

This article does not do us longs any justice. We always criticize the shorts for putting together articles that spew out FUD, half-truths, misinterpretations, etc. and yet this article does the exact same thing to at least a small degree.

1.

The effect on valuation: Simply correcting the cost of capital in Prof. Damodoran’s spreadsheet to 0% in 2014 (the correct figure that corresponds to guidance to growth on internally generated cash from sales) produces a valuation of $200.56. This is before correcting additional clear errors of assumption.

No, this is not the correct figure. How is anybody supposed to take this article seriously if you don't understand the basic concept of cost of capital and the cost of internally generated cash? You are trying to take a professor to school, but it is you who needs schooling (page 5 titled: The Cost of Common Equity)

http://educ.jmu.edu/~drakepp/principles/module7/coc.pdf

2. I also stumbled across this paragraph right above that one:

Regarding dilution resulting from Silicon-Valley style employee options, note that the largest block (5.27 Million shares) is allocated to CEO Elon Musk in return for achieving a contracted performance target of 300,000 cumulative production and $43.2bn Market Cap. Elon Musk reiterated on record as recently as Tuesday (in Munich) that his TSLA holding will be the last Tesla shares to be sold. It is a fair presumption therefore that his options will remain un-exercised until such a juncture and thereby incur no dilution to the portfolio of any external TSLA investor.

First of all it is not 5.27 million shares, but rather 5% IIRC (you can find the answer here: Tesla Motors - Quarterly Report), and then you make it sound like there are only two criteria. This is all besides the point, because the bigger point is that you say that there is "no dilution". This once again is not true.

These stock options have a 10 year expiration date and they will expire afterwards if not exercised. Therefore if Elon meets all 10 of the goals (and not just the two you stated, such as 30% gross margin for four consecutive quarters) then he will receive those shares and it will be considered dilution to all of the other shareholders. It is more than 5.27 million shares; will probably end up being 7 or 8 million shares.

I am sure that the rest of the article is great, but I could not get myself to read it. How can someone trust that the rest of the information in it is accurate or reasonable after making such simple blunders?

The shorts are going to dismiss the article because of simple errors like this one, and rightfully so. 0% cost of capital is a rather big mistake to make.

I am sorry for being so blunt, but this is how I feel. If we are going to promote articles that show the bullish side of valuation then lets at least use correct assumptions. Because if someone is trying to give me a lesson on stock valuation, and doesn't understand the simple concept that internally generated cash has a (rather high) cost of capital, then I can't take anything in that valuation seriously.

Just some honest feedback. It could have been a great article, but one big blunder will negate that very quickly, because people (especially shorts) will only focus on the big blunder.

 

[Julian Cox]

I have been around this since 2008. I was a Roadster buyer. He was thanking us for buying that to fund the Model S. So perhaps I am a bit more immune to the Elon Musk charm. Elon is not above basic cash flow and capital costs. I am just repeating myself so I won't bother typing it all out again. Time will tell. But don't be shocked if they need to raise more cash. Just my opinion.

Respectfully that is not an answer to the question. I get it that you may be a jaded Roadster owner and for whatever reason you feel that way, that of course sucks and I am sorry to hear it.

What interests me is the disparity of the standard of proof lazily assumed to be required to prove a negative vs a positive when in fact the only thing that matters is accuracy.

As the TSLA shorts have experienced over and over again, it is entirely possible to invest on an inadequately well constructed short thesis and lose your shirt.

Inability to believe the long thesis is even close to a short thesis either.

For example, I absolutely LOVE David Einhorn's take down of Allied Capital. David Einhorn: The Speech Part 1 - YouTube
That IMO is what a short thesis ought to look like: This number cannot be because of this, and this, and this, and this all of which known to be true, and if this is true then so is the predicted outcome for the stock.

By this standard there has never been anything approaching a realistic short thesis for TSLA outside of the bounds of attempts to time volatility - for example I personally theorised the conditions required for a dip following the battery swap announcement, the conditions were met and the stock dipped.

Compare the logical construct produced by Einhorn with this:

"I just don't really feel that it's possible to achieve xyz". Why? "because I am just not that enamoured with Musk"

No disrespect intended, but would you or anyone else invest money in a long thesis that was the logical inverse of this argument?

For example: "I just feel that it is possible to achieve xyz" Why "because I think Musk is really nice". No!

 

[tumbledog]

No, I have not. There are *many ways* in which the cost of capital and concordant discount rates affect the bottom line of Tesla Motors going forward. What Julian did was zero out this number *in the specific portion of Damodaran's model related to future capital financing* because IN THAT MODEL this is how it is constructed. Mr. Damodaran's valuation spreadsheet does not project a complete 5-year pro forma financials model (something more like this) unless I'm missing something so it is difficult to quickly gain visibility into the calculations, and changing the cost of capital to zero has the effect of zeroing out future fundraising calculations without going through every cell of the model. Which is why Julian did it, for illustrative purposes.

I believe that you have an extremely poor understanding of Damodaran's spreadsheet and the mechanics of valuation in general.

 

[FluxCap]

Sleepy, is there another way that you would modify Damodaran's spreadsheet to reflect a hypothetical elimination of all future debt/equity fundraising activities of this company and then back into a share price? Because zeroing an input in a spreadsheet model for the sake of speed is not even remotely the same thing as misunderstanding the entire concept of the cost of capital.

Edit: On the input sheet, Damodaran uses a Working Capital Turnover Ratio (he calls it Sales to Capital Ratio) of 1.41 for Tesla based on "industry average" of the old-school automotive sector. I think this number is way, way low. He uses this ratio to DIRECTLY compute the portion of revenues reinvested in the firm. Adjusting it up is another way to tweak this model successfully without touching the cost of capital input. He also shows a negative EBIT margin in the immediate out years, and a margin% growth vastly below the projections Elon has guided. Both of these are so conservative as to be misleading, I think.

Damodaran says in the comments for this input: "You are probably wondering what this is but it is how I compute how much you are going to reinvest to keep your business growing in future years. The higher you set this number, the more efficiently you are growing and the higher the value of your growth. Again, look at your company's current number (divide cell B3 by the sum of cells B5 and B6). Look at the industry averages as well in the worksheet.

 

[Palpatine]

Weighted average shares March 31, 2012 = 104,784,343
Weighted average shares June 30, 2012 = 105,242,452
Weighted average shares March 31, 2013 = 114,711,899 (fully diluted is 124,265,292 meaning the difference (over 9.5 million shares) are mostly options or convertible issues in the money)
Weighted average shares June 30, 2013 = 118,193,608

So there is certainly some dilution already baked into this.
Elon is likely to hit his 5.27 million option target so that is probably included in that 124 million fully diluted share count.
The bulk of the 9.5 million option shares are likely in the money and should be considered in any analysis.
Most of those options are likely priced below $50 per share. Elon's big block is priced at $31.17 so TM will receive about $164 million when he exercises in about 8-9 years.

 

[ModelS8794]

You now have at least three people on this thread telling you the same thing: you lack a basic understanding of the underlying assumptions of a DCF model and how they reflect assumptions regarding business performance. I would suggest getting up to speed on the subject matter, and update and retract the nonsense in your article, if you really have a desire to hold yourself out as one who provides "expert analysis", as the title of this thread implies.

 

[FluxCap]

The factors that are most relevant and obviously in contrast to likely future progress are, IMO:

1) pace of Operating Margin improvement, which Aswath has bumping along from an irrelevant -2% from the last 12 months, to 12% in 10 years. The reality is EBIT margins are already (in year 1 of his analysis) equal to where he models that number only reaching in Year 6. (I use lease-adjusted figure here b/c this is a FCFF model and cash EBIT margins are the relevant figure in this type of analysis)

2) Pace of revenue growth - Aswath uses a typical high growth in early years, low growth in later/mature years approach. With Tesla this leads to bad output because revenue will exhibit much less homogeneous growth rates because platform introductions introduce step-changes in revenues from year to year. Additionally, Tesla's revenue growth in year 1 is severely underestimated, because it works off a base that looks to Last 12 months, which includes a 6 month period where production was closer to 0 than current run-rates. NTM revenue is likely to be closer to $2.5 Billion, a 90% growth rate, versus the 70% growth rate in his model. and so on, with the Model X launch in year 3, and the Model E launch in year 6/7.

3) ROIC - In this world of cash flow modeling that we've entered here, ROIC is probably at once the most important and least estimate-able metric in the model. This is IMO the key debate point over which tesla from $160 will live or die. If this turns out to be just another auto manufacturer with huge capital intensive spending needs and low returns on that investment, then that will mean low ROIC, because tesla will have lower margins, higher annual reinvestment needs, and negative free cash flow for many years versus what is needed to justify current prices. On the other hand, if tesla ends up with substantial brand power and well-spent R&D, that will lead to sustainable and high EBIT margins, lower reinvestment needs, positive free cash flow earlier on, and therefore high ROIC and less need for dilution from capital raises.

When I putz around with his model and insert margin and reinvestment rates that are more in line with a brand power and R&D intensive vs. capX intensive firm, the outputs change quite dramatically. I would therefore love to hear more from those inclined to discuss these aspects of Tesla's business model.

Edit: On the input sheet, Damodaran uses a Working Capital Turnover Ratio (he calls it Sales to Capital Ratio) of 1.41 for Tesla based on "industry average" of the old-school automotive sector. I think this number is way, way low. He uses this ratio to DIRECTLY compute the portion of revenues reinvested in the firm. Adjusting it up is another way to tweak this model successfully without touching the cost of capital input. He also shows a negative EBIT margin in the immediate out years, and a margin% growth vastly below the projections Elon has guided. Both of these are so conservative as to be misleading, I think.

I find myself in complete agreement with your criticisms of Damodaran's assumptions here. When I putz around with the model I arrive at the same conclusions, as I posted above.

You now have at least three people on this thread telling you the same thing: you lack a basic understanding of the underlying assumptions of a DCF model and how they reflect assumptions regarding business performance. I would suggest getting up to speed on the subject matter, and update and retract the nonsense in your article, if you really have a desire to hold yourself out as one who provides "expert analysis", as the title of this thread implies.

I think Julian wrote this extensive article rather fast and maybe didn't take the time to consider all the inputs in Damodaran's spreadsheet thoroughly. So he may have changed an input that should have been left alone. I don't think that negates the other extremely useful and valid points he makes in his analysis, nor do I think it is evidence of a complete misunderstanding of the concept of cost of capital, the time value of money or WACC and the DCF model. I could of course be wrong.

 

[PeterJA]

You now have at least three people on this thread telling you the same thing:..

And these three people have not answered the question asked by three other people (myself, Flux, and Convert), namely:
If you don't like the way Julian modified Damodaran's spreadsheet, then how would you do it to reflect the assumption of no further capital raises (or the amount of capital raise you believe), and what share price pops out?

This is an important question, is it not? Since you think it's such a shame that people may act on Julian's estimate, how far off is his estimate from yours?

A teacher who can only say "you're wrong" but can't say what's right is not much of a teacher.

 

[Julian Cox]

You now have at least three people on this thread telling you the same thing: you lack a basic understanding of the underlying assumptions of a DCF model and how they reflect assumptions regarding business performance. I would suggest getting up to speed on the subject matter, and update and retract the nonsense in your article, if you really have a desire to hold yourself out as one who provides "expert analysis", as the title of this thread implies.

Firstly, I have no desire to elevate my personal status as you have implied, while I am grateful for the compliment in the title I can assure you I had no hand in it.

Secondly, the concept of applying a cost of internally generated cash to a DCF model is ridiculous when in fact the whole point of DCF is to place a value on Cash Flow from internally generated cash.

Thirdly Damadaran is clearly and incorrectly implying a cost of externally generated cash, I believe deleting it is an appropriate shorthand for rebuilding the entire model (with the base principles of DCF in mind as a matter of fact). I am not convinced of the merit of sniping about dictionary definition semantics on this one point when one can drive a coach and horses through the whole thing from almost any angle - growth assumptions off by approaching an order of magnitude for example due to analogy with the growth constraints of mature businesses in a saturated market and an impossible additional presumption of Tesla's confinement to a niche of it.

Fourthly if you believe you are capable of building a valuation model for Tesla why not go ahead and contribute such a thing, if it is any worth maybe someone will be generous enough to repost it with the word expert in the title.

 

[Palpatine]

And these three people have not answered the question asked by three other people (myself, Flux, and Convert), namely:
If you don't like the way Julian modified Damodaran's spreadsheet, then how would you do it to reflect the assumption of no further capital raises (or the amount of capital raise you believe), and what share price pops out?

I have not done a spreadsheet, but I put the amount of cash needed at about $3 billion cash or cash equivalents needed to support the scale of an enterprise doing $15 billion in sales (roughly 300,000 cars per year at an average of $50,000 per car).
In that assumption I believe TM has $750 million now and is planning towards cash flow neutral in the near term. But I expect scaling up for Model X in 2014 will burn some cash.

Sometime in 2015 I suspect they will need money to scale up production of Gen III.
$1.5 billion raised would be dilution of 7.5% if they have a market capitalization of $20 billion when they do the secondary offering.
$2.0 billion raised would be dilution of 10%.

Although, it is wild guess now as to the market capitalization in the future. So the cost of the capital could be a wide range at that time.

Also above it is clear that some employee options are being exercised based on the average weighted share count rising each quarter, so there is some incoming cash from financing activities as employees cash out some option wealth. That activity will likely show up some in the cash or cash equivalents number each quarter. This option activity will slightly hide whether or not TM has cash burn from operations.

 

[ModelS8794]

And these three people have not answered the question asked by three other people (myself, Flux, and Convert), namely:
If you don't like the way Julian modified Damodaran's spreadsheet, then how would you do it to reflect the assumption of no further capital raises (or the amount of capital raise you believe), and what share price pops out?

This is an important question, is it not? Since you think it's such a shame that people may act on Julian's estimate, how far off is his estimate from yours?

A teacher who can only say "you're wrong" but can't say what's right is not much of a teacher.

i have answered your question twice already. Flux put the material directly in this thread as well, so you actually have 3 specific responses to choose from.

To to assume no further capital raise begs the question, and will only lead you to find answers that fit the preconceived conclusion. Whether or not outside capital is necessary is an output of the analysis, not an input.

You keep asking for a share price. The number is irrelevant; this is business analysis, not a magic 8-ball. it is the assumptions that matter and that is why I endeavor to explain which assumptions are most clearly erroneous in Aswath's model, as well as why the basic premises of Mr cox's analysis are flawed.

You can go back and read the long term investing thread that I linked to for one example of some minor adjustments that produce a ~$200 share price. But as I said before, I really dont don't see the value of using a poorly structured set of DCF assumptions as a basis for analysis that we then go about tweaking in order to try and find the "right answer." It's much more useful to investigate what the business characteristics are (brand power, moat, margin potential, likely capital intensity, and on and on) that result in the various model assumptions, and determine to what extent Tesla looks "normal" and to what extent it needs to be "abnormal" in order to justify today's price.

Sorry i I don't have a cleaner answer for you.

 

[Julian Cox]

This article does not do us longs any justice. We always criticize the shorts for putting together articles that spew out FUD, half-truths, misinterpretations, etc. and yet this article does the exact same thing to at least a small degree.

Sleepyhead, FYI as a matter of fact I questioned Kevin on the wisdom of unpublishing your piece from investinaire and while in all honestly I was surprised to find myself impressed with his answer, it would not have been my first choice. I never got the chance to read your piece.

I understand your views are generally well respected here and I for one would have valued the opportunity to run this piece past you with a view to assisting in eliminating vulnerabilities to wilful misinterpretation in advance. It would have been worth framing the treatment of cost of capital with more explicit instructions that this was the elimination of an error relating to presumed external cost of capital explicitly contrary to guidance and done in order to expose a more realistic picture of future cash flows.

One way or another I remain satisfied that despite my ignorance of the vulnerability to the criticisms you have highlighted this piece presents an infinitely more reasonable and realistic picture of the business of Tesla than the waves of wilfully misleading commentary it seeks to address.

 

[PeterJA]

These forums are rife with gushing praise of mr. Cox's expertise, and more than a handful of forum members are clearly taken enough with his analytic prowess that they are committing real dollars to his conclusions. This is a shame.

You keep asking for a share price. The number is irrelevant; this is business analysis, not a magic 8-ball.

Call me simple-minded. When you say a man's conclusion (that TSLA is undervalued) is so flawed that acting on it is a shame, I don't think your alternative conclusion is irrelevant.

You can go back and read the long term investing thread that I linked to for one example of some minor adjustments that produce a ~$200 share price. But as I said before, I really dont don't see the value of using a poorly structured set of DCF assumptions as a basis for analysis that we then go about tweaking in order to try and find the "right answer."

Julian never claimed to have the "right answer" for the current share valuation. He clearly said that changing ONLY TWO assumptions of Damodaran's model (among others that could be changed) to more realistic values for Tesla results in a dramatically higher share price. His goal was to debunk the $67 valuation that got so many headlines, and to give a qualitative estimate of the correct valuation (higher than the current price).

It's much more useful to investigate what the business characteristics are (brand power, moat, margin potential, likely capital intensity, and on and on) that result in the various model assumptions, and determine to what extent Tesla looks "normal" and to what extent it needs to be "abnormal" in order to justify today's price.

Julian did that in the rest of his recent article, and in his previous article on SA. I would read that one before I declared what a shame it is that people are acting on his conclusions.

 

[ModelS8794]

Call me simple-minded. When you say a man's conclusion (that TSLA is undervalued) is so flawed that acting on it is a shame, I don't think your alternative conclusion is irrelevant.

Julian never claimed to have the "right answer" for the current share valuation. He clearly said that changing ONLY TWO assumptions of Damodaran's model (among others that could be changed) to more realistic values for Tesla results in a dramatically higher share price. His goal was to debunk the $67 valuation that got so many headlines, and to give a qualitative estimate of the correct valuation (higher than the current price).

Julian did that in the rest of his recent article, and in his previous article on SA. I would read that one before I declared what a shame it is that people are acting on his conclusions.

peter, the problem here isn't that he is or isn't reaching the right conclusion. If a different sophist abused the queen's english to write an article about the moon's alignment with Jupiter demonstrating Tesla's undervaluation, it would receive equal derision and the derision would equally stem not from the conclusions, but from clear lack of logic behind the argument. And it would be equally nonsensical to then ask "well if you think he's so wrong, then just tell us what degree of alignment with which planet you would use in the model so we can judge just how far off his conclusions are." Do you see why?

As as another member wrote upthread, one cannot simply ignore the garbage and focus on 'the good stuff'. The writer's lack of basic comprehension on such fundamental aspects of the thesis he himself sets out to make undermines any claims made anywhere else.

This is why I hope Mr. Cox comes to a much needed reality check of his own, so he can recognize the flaws in his logic, retract the silly stuff, and quit the sophistry.

The tesla investment community will benefit from clear examination of the good bits of his argument, once we can rid ourselves of nonsense like "the concept of applying a cost of internally generated cash to a DCF model is ridiculous when in fact the whole point of DCF is to place a value on Cash Flow from internally generated cash." Or "It would have been worth framing the treatment of cost of capital with more explicit instructions that this was the elimination of an error relating to presumed external cost of capital explicitly contrary to guidance and done in order to expose a more realistic picture of future cash flows."

These constant demonstrations of ignorance only continue to distract us from more useful discussions which are taking place elsewhere on this forum - THAT is the real problem with sophism like his, not just that it's flawed, but that it's flawed and gets so much attention. (As I write these thoughts down I am coming to the realization that I've probably contributed to that shameful state of affairs...)

 

[DonPedro]

This article does not do us longs any justice. We always criticize the shorts for putting together articles that spew out FUD, half-truths, misinterpretations, etc. and yet this article does the exact same thing to at least a small degree.

1.

The effect on valuation: Simply correcting the cost of capital in Prof. Damodoran’s spreadsheet to 0% in 2014 (the correct figure that corresponds to guidance to growth on internally generated cash from sales) produces a valuation of $200.56. This is before correcting additional clear errors of assumption.

No, this is not the correct figure. How is anybody supposed to take this article seriously if you don't understand the basic concept of cost of capital and the cost of internally generated cash? You are trying to take a professor to school, but it is you who needs schooling (page 5 titled: The Cost of Common Equity)

http://educ.jmu.edu/~drakepp/principles/module7/coc.pdf

2. I also stumbled across this paragraph right above that one:

Regarding dilution resulting from Silicon-Valley style employee options, note that the largest block (5.27 Million shares) is allocated to CEO Elon Musk in return for achieving a contracted performance target of 300,000 cumulative production and $43.2bn Market Cap. Elon Musk reiterated on record as recently as Tuesday (in Munich) that his TSLA holding will be the last Tesla shares to be sold. It is a fair presumption therefore that his options will remain un-exercised until such a juncture and thereby incur no dilution to the portfolio of any external TSLA investor.

First of all it is not 5.27 million shares, but rather 5% IIRC (you can find the answer here: Tesla Motors - Quarterly Report), and then you make it sound like there are only two criteria. This is all besides the point, because the bigger point is that you say that there is "no dilution". This once again is not true.

These stock options have a 10 year expiration date and they will expire afterwards if not exercised. Therefore if Elon meets all 10 of the goals (and not just the two you stated, such as 30% gross margin for four consecutive quarters) then he will receive those shares and it will be considered dilution to all of the other shareholders. It is more than 5.27 million shares; will probably end up being 7 or 8 million shares.

I am sure that the rest of the article is great, but I could not get myself to read it. How can someone trust that the rest of the information in it is accurate or reasonable after making such simple blunders?

The shorts are going to dismiss the article because of simple errors like this one, and rightfully so. 0% cost of capital is a rather big mistake to make.

I am sorry for being so blunt, but this is how I feel. If we are going to promote articles that show the bullish side of valuation then lets at least use correct assumptions. Because if someone is trying to give me a lesson on stock valuation, and doesn't understand the simple concept that internally generated cash has a (rather high) cost of capital, then I can't take anything in that valuation seriously.

Just some honest feedback. It could have been a great article, but one big blunder will negate that very quickly, because people (especially shorts) will only focus on the big blunder.

+1000000.

I thought exactly the same thing: This post does a great disservice to the longs.

There are two basic things conflated here, which may be the clarification you are asking for, PeterJA:

1. No more dilution: The controversy here is about whether or not Tesla can grow as fast as Julian thinks (i.e. grow 512-fold in 9 years) without raising cash. This is a standalone discussion that has nothing to do with the percentage rate used for cost of capital in a discounted cash flow analysis. I am with Palpatine and others on this: The "512-fold" assumption is insanely aggressive, and hard to reconcile with organic growth. I think you either assume that all growth will be organic, in which case you have to reduce the percentage growth rate a bit over time, or you make the 512-fold assumption and assume they will need cash. As a thought experiment, you could think about how they would grow capacity from 5 million cars in 2021 to 10 million cars in 2022 without any external cash for neither production capacity nor working capital. In my mind we are in complete fantasy-land here. But there is nothing inherently wrong with Julian's assumptions on this point, they are just beyond belief for some of us. The number in Prof. Damodaran's spreadsheet that is affected by this assumption is the capital ratio of 1.41 (which Julian should set to near-infinity to account for his assumption). However, instead Julian conflates this assumption with the assumption about the percentage cost of capital: "To reiterate, when entering the correct figure according to guidance and with proper appreciation of the Tesla cash flow model for cost of capital in the period 2014~2018 (which is 0%, not 9.18% or 10.79%) Prof. Damodoran’s calculations yield a net-present valuation as at September 4th 2013 of $200.56.".

2. Cost of Capital: The cost of capital is a percentage you apply to the analysis to take account of the fact that shareholders care more about profits today than later (the cost of equity) and that creditors demand a price for lending money (in Tesla's case, they get a combination of 1.5% cash interest and options to buy the stock at ~$182). It is easy to see that this is so. Who would want to own TSLA if the prospect was a one-off yield of $200 in 10 years? You could make more by putting your money in the bank, and that would be risk free. To adjust for that, you calculate the Cost of Capital. All companies have a cost of capital, and it consists of a risk premium on top of a risk free rate. It is completely irrelevant whether the companies are going to raise cash in the future or no. Just ask yourself: How much more than a bank deposit should I expect Tesla to yield for it to be a good investment. The answer will be "quite a bit", and I think that any judgment between 6% and 12% is reasonable. The convertible loan was priced low, but not at 1.5% (because part of the return to the lenders are the options inherent in the convertible loan). Using the 1.5% for any sort of financial analysis is clearly an error, unless you adjust that rate for an expected return on the option to convert).


Beyond this confusion, the part about Elon's options was completely illogical. I will not go into this, as Sleepyhead explained that well.


[QUOTE author=Sleephyhead]I am sure that the rest of the article is great, but I could not get myself to read it. How can someone trust that the rest of the information in it is accurate or reasonable after making such simple blunders?[/QUOTE]

This is exactly what happened to me as well.

 

[FluxCap]

Folks, I am the one who called Julian an "expert" and posted this thread. If you want to take issue with that, please do so with me and not Julian. He didn't ask for me to link this analysis.

Also, I think there is a lot of testosterone and ego flowing around here right now. Perhaps we could take Bonnie's advice and ratchet that down a couple notches? Perhaps we could direct our energies towards constructing a more complete analysis of Tesla, and discussion of the issues we all agree on?

I remain confident that there is a large amount of very useful and insightful information and analysis in Julian's piece, and do not believe it is worth throwing out the entire article despite concerns that have been raised, valid or not. There are many sections of the article which are in direct agreement with arguments those in this thread who are critical of Julian have also made. Perhaps we could focus on those as well?

Let's move on.