What Hath Elon Wrought?

How to value Tesla

Tesla’s soaring valuation — it breached the $1 Trillion level recently on the news that Hertz had placed a massive order for Model 3s– continues to confound some market watchers. By conventional metrics, neither its sales nor profits, even projected explosively, merit such riches. (CEO Elon Musk, himself, wondered why the Hertz order had spiked the valuation, since the company isn’t lacking demand for its products.) Meanwhile, Tesla bears are packing it in: The percentage of Tesla stock borrowed by traders has slumped to its lowest level since the company went public.

So, what gives? Is the stock untethered from reality, pumped full of helium by market sentiment, destined to pop at a certain altitude?

Here’s my explanation (I’m sure you’ve heard this statement before since it’s applied periodically to high-flyers. But don’t roll your eyes yet;): Conventional metrics such as multiples of the price to earnings ratios don’t apply in this stage of the company’s life.

Tesla stock may well revert to the mean at some point, but so far it is buoyed by several “premiums” accorded to it by the market: For customer loyalty, for execution and for its vision. The company benefits from unmatched customer loyalty (possibly greater than Apple’s) and, despite the occasional stumble, it continues to demonstrate a remarkable ability to execute on its vision, which happens to be nothing less than the electrification of the economy.

Customer loyalty is the easiest to understand. As an owner of a Model 3, I can vouch for the fact that the sheer joy of driving a Tesla is unlike anything I’ve experienced in half a century of driving. As the adage goes, “It’s not how fast it goes; it’s how well it goes fast.” (Note that it’s purely the powertrain and the handling that I’m talking about, not anything to do with the self-driving gimmicks.) The “Teslaratti” would agree that once you own a Tesla, you’re not likely to switch.

That customer loyalty is an economic asset is somewhat obvious, of course, but too often ignored by stock analysts. (I am not one). Yet, it can be proved that a loyal customer base translates to higher returns and lower market risk.

The execution premium has at least three components: Innovation; the “Gigafactory,” philosophy of manufacturing and vertical integration.

Realizing that “range anxiety” would be the Achilles heel of the electric vehicle, Tesla focused on continuous innovations in battery and motor technology. In both those areas it is now miles ahead of competition.

Tesla’s also gone all out in addressing another concern about EVs: Battery replacement cost. The battery is the most expensive component of an EV. All batteries degrade over time until they can no longer hold enough charge to power the vehicle. Today’s batteries typically last for 250,000 to 300,000 miles before they need to be replaced, with Tesla at the high end of that range. But soon Tesla is set to debut its “million-mile” battery in China, a tour de force that relies on advanced chemistries plus new chemical additives, materials and coatings designed to reduce internal stress and enable greater energy storage for longer periods.

Greater energy storage is but one side of the coin; reducing energy loss in the powertrain is the other. According to Tesla, an improvement in motor efficiency by 8 to 10 percent increases range by 15 to 18 percent. Tesla told Car and Driver magazine that the motor in the Model S has gone from 80 percent efficient to 90 percent, with peak efficiency at 94 percent during the EPA test cycles. Early Teslas used AC induction motors (invented by Nikola Tesla himself). Later models, starting with the Model 3, switched to brushless permanent magnet DC motors. Even later models use motors with both magnetic and reluctance actions to achieve both high starting torque and efficient cruising.

And earlier this year Tesla unveiled another tour de force: Its so-called Palladium motor technology that uses a carbon-sleeved rotor to create extreme efficiency with high power and small size. Tesla had to design a new manufacturing machine to wind it, a “super hard thing to do,” according to Musk.

The execution premium also reflects the fact that Tesla’s Gigafactory model is a revolutionary approach to manufacturing — for everything, not just cars. There are four such monster factories — three in the US and one in China — in various stages of operational capability, with at least four more on the way.

The Gigafactory model represents a full-fledged embrace of the Experience Curve theory — first postulated by the Boston Consulting Group, nearly fifty years ago — that posits that manufacturing costs decline predictably with accumulated production experience. What that means is that you can price to gain market share — even if it means selling below cost — with the full confidence that your production costs will decline (and your production margins will grow) as your cumulative volume increases. Specifically, the Experience Curve predicts that total manufacturing costs would decline between 15% and 25% for every doubling of cumulative volume. By pumping out high volumes — of cars, of batteries, of solar roof tiles, of Powerwalls — a Gigafactory allows Tesla to manage costs and margins predictably. ARK Invest’s Sam Korus uses Wright’s Law — a special case of the Experience Curve, specific to labor costs — to show that the Model 3’s gross margin would double to 30% within the next 18 months.

High volume production focused on predictable cost declines is not the only benefit of the Gigafactory. It’s vital to Tesla’s vertical integration strategy. Tesla builds its own motor, inverter, battery pack, and other items under one roof instead of sourcing off the shelf parts from a Tier 1 supplier. A tight integration approach not only allows Tesla control over much of its supply chain, but crucially, allows it to continually tweak those parts so that they work together with maximal efficiency.

The vision premium (I prefer the term Changing-The-World premium) is impossible to quantify, of course. Tesla sees itself as something much bigger than an EV company. It’s aiming to be the hub of the electric economy. And, the Gigafactory strategy is central to realizing that goal. Gigafactory-made Tesla battery packs are already being aggregated into massive battery farms. And solar roof tiles are being stamped out at Gigafactory 2 in Buffalo. The cheaper they get, the less need to optimize solar exposure of roof tops.

Visions aren’t afforded premiums unless it looks like they are likely to become reality. Tesla’s only getting started, but based on its track record it’s already being rewarded for changing the world.

So far, so good, but It’s also impossible to quantify the effect of the wildcard that is Elon Musk. On the plus side is the fact that he’s spectacularly realized at least one part of his vision — creating the EV industry and striking a huge blow for sustainable energy. It’s a magnificent achievement, but a tough act to follow, especially if the sequel is a bigger one — changing the economy. It requires a leader with a singular focus. Musk, however, has several irons in the fire including a company that shoots rockets into space and another that digs tunnels into the Earth. But here’s the biggest concern: The very real possibility that Musk may be distracted by another aspect of his vision — creating the driverless car. For that, I believe, is a futile quest whose path skirts the edge of human knowledge.

Will the greatest engineering visionary of our time be undone by his obsession with the impossible? Let us see. An irresistible force is about to meet an immovable object.