Trading ideas beyond Sharpedge Portfolio.

Hi everyone! We continue our trading ideas section. The link to TradingView post with the idea is available here.

Recently Tesla surpassed Toyota in capitalization, which was the biggest auto manufacturer for the last two or three decades. I’d like to analyze this situation and argue that it may be a good time for a put option on TSLA .

Before I continue, I'm obliged to disclose the fact that I do not hold TSLA put options and only consider buying. As always, please note that this analysis is my point of view, and trading is a risky activity. You are the only responsible for your trading actions. Now, with disclaimers being said, let's take a look at the trade.

Let’s start with a short background. TSLA is a well-known company founded by Elon Musk, whose reputation and charisma attracted a lot of attention to the company. It specializes in electric cars, and recently, they announced and presented their pick-up, Cybertruck. Cybertruck pre-orders surged. Fox business article published on February 19, 2020, stated that the number was about 535k, which means it can be about 1 million right now. The stock price plunged during the COVID-19 crisis but rebounded pretty fast and set a new all-time high.

Let’s analyze the situation and try to answer the question – is the current price fair for TSLA stock? 

As usual, I’ve started with fundamental parameters. I prepared a short PDF comparing key ratios and statistics for the leading automakers using Capital IQ. You can find the file here. Below I list several conclusions about the TSLA. In particular, I compare TSLA with TM (Toyota), which was the leader of the auto industry for decades.

• First of all, Tesla is still the smallest company among the core producers, with revenue being about three times lower than that of the closest competitors (Peugeot) and more ten times lower than that of Toyota. In the auto industry, the average ratio of Enterprise Value to Revenue is about 0.8, which means the companies, on average, cost a little bit less than their yearly revenues. The corresponding value for TSLA is 8.9. This is more than ten times bigger than the average, and this is, basically, the only outlier in the distribution because, excluding TSLA, the highest value of the ratio is just 1.3 for BMW.
• Second, analyzing EBITDA, which is a P&L item that shows how much money the company generates, we can see that Tesla is doing pretty well. If you check the EBITDA margin column, you will that TSLA is the most efficient American company, and it even competes with BMW and Volkswagen AG. Still, the margin is below that of Toyota, and the TSLA’s ratio of Enterprise Value to EBITDA is many times higher than the average (67 against 9.8). So, despite being efficient, the company’s value seems to be exaggerated.
• Third, let’s analyze the forward P/E ratio. Forward P/E ratio shows you how many years a company has to operate to generate earning per share to compensate investors for the price. The difference between forward P/E and standard P/E is that in forward ratio, we use the forecasted earnings. It means that forward P/E already accounts for the growth of earning that happens in the next 12 months. As you see in the table, the industry’s average is 16, while TSLA’s ratio is 212. It means that if the company keeps its’ operations at the level of the next 12 months, investors will have to wait for 212 years for the company to earn enough to compensate for the price.

Ok, so we considered several fundamental valuation multiples and state that the company may be overvalued. Now, the core argument against overvaluation can be as follows: 

“The company value is a present value of all cash flows, and, given extremely high earnings and revenue growth, the value is a fair one.”

That is the statement I read quite often. It tries to apply classical finance valuation approaches to emotional bubbles, which works only until the bubble blows up. In the case of Tesla, we need to take into account several essential facts.

• First of all, at this stage of the company, the growth rate is certainly diminishing. That means every next year we will see the growth rate that is lower than the current year’s.
• Second, the company’s key asset right now seems to be Cybertruck. I remind you that Cybertruck pre-orders hit 1 million. However, there are two clarifications. First, the US is the number 1 country in terms of pick-up sales, so don’t be surprised by the figure. According to goodcarbadcar.net, every month, there are about 250 thousand pick-up sales in the US, and Ford alone sells 1 million F-series per year. And here comes the second clarification. Having pre-orders on 1 million units doesn’t mean Tesla can quickly produce 1 million units. In fact, when the number of pre-orders was 250 thousand, Elon Musk said they would need four years to produce them. We can assume that the target capacity of Tesla was about 60-65 thousand Cybertrucks per year. That means, to secure the cash flow from 1 million Cybertrucks, they either need 15 years or a fast expansion, and here comes our final point.
• Tesla is still a pretty small company comparing with BMW, Toyota, Volkswagen, Ford, General Motors, and others. Right now, they certainly need to scale, and scaling introduces many challenges and risks to the company’s marginality. The thing is that in some point economy of scales turns into a de-economy of scale because of the complexity of the structure – you need to have more and more people in supporting activities, such as HR, PR, IT, Finance, etc. All those activities serve as an infrastructure for core production and don’t add value. And if growth rates have diminishing functions, complexity follows exponential function. One account may be enough for two factories, but for ten factories you may need ten accountants because of structural complexity. Tesla still has to make this move; it still has to do a lot of expansion work. This leads to additional operational risks and a high chance of seeing a lower EBITDA margin in the future. Unexpectedly high demand for Cybertruck may force then to grow faster, which, once again, increases risks. 

So, what’s the bottom line? The bottom line is that TSLA may be a great company, it may become a new Toyota, but right now, it seems overvalued because of public emotions and hype. If we include technical indicators in our analysis, I can mention the following:

• Relative strength of TSLA (which is a ratio of TSLA to S&P ), you will see a dramatic surge, which once again tells us about an unfair price.
• Since June, insiders sold stocks worth 10 million dollars. Such a behavior once again indicates that even the management considers the price to be high.

What can be done in such a situation? Well, first of all, don’t short the stock directly! With such a strong trend, it may be a trading suicide. What I suggest is to consider buying put options. 

For those who don’t know much about options, the put option gives you the right but not the obligation to sell the stock at a predetermined price for an upfront premium. So basically, you pay, let’s say 50 dollars per trade and fix your right to sell the stock at 1000 dollars in the next two months. If the price falls at least 51 dollars, you earn. If it doesn’t, then you lose your premium, the worst case. 

Buying put should be accompanied by either a bearish candle pattern or volume surge, which I consider to be the best climax pattern. So, with this in mind, let’s wait and see what happens.