NARRATIVE AND NUMBERS:

LIGHT IN THE DARKNESS!

When in trouble, go back to basics!
The Bermuda Triangle of Valuation

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Valuation First
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Principles &
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Good Sense
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Uncertainty & the Unknown
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Tesla: What are your priors?

¨ With Tesla, there are no neutral observers. There are

people who love the company or hate it. Almost no
one has no opinion on the company. What is your
prior?
a. I love the company. It will be a trillion dollar company.
b. I hate the company. I think it is a scam
¨ Tesla also happens to be a personality-driven
company. What you think about Elon Musk will
mirror what you think about Tesla. What are the
potential concerns you should have about that
interleaving of the personal and the corporate?
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Valuation Uncertainty

What is the value added by growth assets?

Equity: Growth in equity earnings/ cashflows
What are the Firm: Growth in operating earnings/
cashflows from cashflows
existing assets? When will the firm
- Equity: Cashflows become a mature
after debt payments fiirm, and what are
- Firm: Cashflows How risky are the cash flows from both the potential
before debt payments existing assets and growth assets? roadblocks?
Equity: Risk in equity in the company
Firm: Risk in the firm’s operations

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The sources of uncertainty

¨ Estimation versus Economic uncertainty

¤ Estimation uncertainty reflects the possibility that you could have the “wrong
model” or estimated inputs incorrectly within this model.
¤ Economic uncertainty comes the fact that markets and economies can change over
time and that even the best medals will fail to capture these unexpected changes.
¨ Micro uncertainty versus Macro uncertainty
¤ Micro uncertainty refers to uncertainty about the potential market for a firm’s
products, the competition it will face and the quality of its management team.
¤ Macro uncertainty reflects the reality that your firm’s fortunes can be affected by
changes in the macro economic environment.
¨ Discrete versus continuous uncertainty
¤ Discrete risk: Risks that lie dormant for periods but show up at points in time.
(Examples: A drug working its way through the FDA pipeline may fail at some stage
of the approval process or a company in Venezuela may be nationalized)
¤ Continuous risk: Risks changes in interest rates or economic growth occur
continuously and affect value as they happen.

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A Life Cycle View

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Healthy Valuation

Favored Tools Favored Tools

- Accounting statements - Anecdotes
- Excel spreadsheets - Experience (own or others)
- Statistical Measures - Behavioral evidence
- Pricing Data
A Good Valuation

The Numbers People The Narrative People

Illusions/Delusions
Illusions/Delusions 1. Creativity cannot be quantified
1. Precision: Data is precise 2. If the story is good, the investment will be.
2. Objectivity: Data has no bias 3. Experience is the best teacher
3. Control: Data can control reality

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The steps in valuation

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The Drivers of Value

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The drivers of value

¨ The Growth Lever: The revenue growth rate controls how much and how quickly the firm
will be able to grow its revenues from autos, software, solar panels and anything else that
you believe the company. In my Tesla story (valuation), I have estimated revenues of $125
billion in 2030, a five-fold increase over the 2019 revenues.
¨ The Profitability Lever: The target (pre-tax) operating margin determines how profitable you
think the company will be, once its growth days start to scale down. In keeping with my view
that R&D is really a capital expense, I capitalize R&D, which improves Tesla’s
profitability and target an operating margin of 12% by 2025.
¨ The Investment Efficiency Lever: To grow, companies have to invest in capacity and the sales
to invested capital drives how efficiently investment is done, with higher sales to capital
ratios reflecting more efficiency. With Tesla, I assume that every dollar of investment (in new
factories, technology and new R&D) in the first 5 years generates $3 in revenue.
¨ The Risk lever: The first is the cost of capital that I start the valuation with, a reflection of
risk as seen through the eyes of a diversified investor in the company. The second is
the likelihood of failure (or distress). With Tesla, I set this cost of capital at 7% and assume
that given its marginal profitability and significant debt load, the chance of failure is 10%.

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The Growth Lever

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The Biggest Auto Companies

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A tech company twist?

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Your growth choice

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The Profitability Lever

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A tech twist?

¨ The median operating margin for tech companies

(including both software & hardware is 10.25%).
¨ The picture is brighter for the FAANG stocks, where
the aggregate operating margin across all five stocks
is 19.87%, well above auto industry averages. That
margin, though, is delivered on smaller revenues and
with business models where production costs are a
small fraction of selling prices.
¨ The operating margin for just software companies is
even higher at 21.24%, because the marginal unit of
software is close to costless to produce.
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Your choice on profitability

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3. The Investment Efficiency Lever

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More on investment efficiency

¨ Looking across global auto companies, the median company

generates $1.37 in sales for every dollar of capital invested,
and at the 75th percentile, the more capital-efficient auto
companies generate $2.42 in revenues for every dollar of
capital invested.
¨ My estimate of $3 in revenues for every dollar of capital
invested reflects an optimistic view of Tesla’s capacity to bring
technological innovation to its production processes, and
reduce the capital needed to fund those processes.
¨ Since Tesla, in 2019, generates $1.32 in revenue for every
dollar of capital invested, my estimate is more aspirational
than based on observable efficiencies, right now.

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Your choice on investment efficiency

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4. Risk: The Cost of Capital - Global

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Your choice on cost of capital & the failure rate

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Valuation Stories

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The Stories
¨ The Big Auto Story: If your story is that Tesla will emerge from its growth period as one of the
largest auto companies in the world (revenues of $100- $300 billion in year 10), with top-tier auto
company margins (7.42%), investment efficiency (2.42) and cost of capital (6.94%), the value per
share ranges from $106/share (with BMW like revenues) to $227/share (with Daimler-like
revenues) to $333/share (with VW/Toyota like revenues).
¨ The Techy Auto Company Story: Tesla is an auto/software/services company with tech company
characteristics, giving it higher margins (10.25%) and a higher cost of capital (8.86%). With this
story, the value per share ranges from $111/share (with BMW like revenues) to $212/share (with
Daimler-like revenues) to $298/share (with VW/Toyota like revenues). Put simply, the higher risk
nullifies the benefits of higher profitability.
¨ The FAANGy Auto Company: Tesla not only develops a tech twist, but becomes as successful as the
most successful tech companies (I use the FAANG stocks + Microsoft). In this story, the margins
approach 18.97% and with a tech cost of capital, the value per share ranges from $459/share (with
BMW like revenues) to $855/share (with Daimler-like revenues) to $2,106/share (with VW/Toyota
like revenues).
¨ The Make-your-best Company: I give Tesla the best possible outcomes on each variable, revenues
like VW/Toyota, margins like pure software companies (21.24%), a sales to capital ratio that is
higher than any of the sector averages (4.00) and a cost of capital of an auto company (6.94%), and
arrive at a value per share of $2106.

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Possible? Plausible? Probable?

¨ With the big auto stories, the key question will be whether Tesla can climb to the
very top of the heap in terms of revenues, generally reserved for mass market
companies, while earning operating margins that are usually reserved for smaller
luxury auto companies?
¨ With the techy auto stories, the key question becomes whether a company that
derives the bulk of its revenues from selling cars be profitable and reinvest like a
tech company?
¨ With the FAANGy stories, the investment question becomes whether you should
up front for a company on the expectation that it will be an exceptional company.
It very well might make it to the top of the heap, but if it does not, you are set up
for disappointment.
¨ With the MYB story, you are approaching the most dangerous place in valuation,
where you pick and choose each assumption, without considering the ones you
have already made. Put simply, is it even possible to build a company that
generates revenues like Toyota, earns margins like Microsoft and invests more
efficiently than any manufacturing company in history has ever done, while still
preserving the low cost of capital of an auto company?

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When a crisis hits, the dark side beckons…

¨ During a crisis, you will be told that you can no longer

value companies with fundamentals, and that you have
to play the trading game.
¤ If your concept of valuation is downloading last year's financials
for a company into a spread sheet and then using historical
growth rates, with some mean reversion thrown in, to forecast
future numbers, they are right.
¤ If your notion of valuation is more dynamic and forward-looking,
it is precisely at times like these that you need to go back to
basics.
¨ More importantly, your story for the company matters
more than ever before, since the numbers can no longer
be used as a crutch.

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How crises affect stories…

¨ Stories can expand: For some companies, a crisis can expand

stories
¤ By allowing them to reach new customers and devise new business
models that have staying power (Zoom, Peloton)
¤ By being in the right place at the right time (
¤ By handicapping or damaging the competition (Tesla, Airbnb)
¨ Stories can contract: For other companies, a crisis can shrink
stories
¤ By making their markets smaller (cruise lines definitely, airlines
maybe)..
¤ By being in the wrong place at the wrong time (commodity companies)
¨ And the risk of failure becomes real and ignorable: And for all
companies, a crisis can increase the likelihood of failure (story
break).

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A Roadmap to Story Telling & Valuation in a
crisis
1. Separate the near term from the long term: During a crisis,
the near-term effects are likely to be both large and
unpredictable (negative for most companies, but positive
for a few). Estimate the near term effects on earnings and
cash flows, using all of the information you have and
bringing in views on how the macro economy will evolve.
2. Revisit your story for the company: Evaluate how your story
for the company has changed as a result of the crisis, and
play out its effect on your long term value inputs (revenue
growth, margins and reinvestment)
3. Bring in failure risk: For your story to play out, the company
has to survive. Incorporate, as best as you can, the
likelihood that your company will not make it through.

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A Post-Corona Version

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It’s only an investment!

¨ Money on the table, but no regrets: In the week since I sold Tesla at $640,
the stock has gone on a wild ride, rising above $900 in two trading days. I.
I made my decision to buy, based on my story and valuation for Tesla, and
my decision to sell, for the same reason. If I abandon that philosophy to
play the momentum game, a game that I am not good at and don’t really
play well, I may make a bit more money, but at what cost?
¨ Why the vitriol? In a world where we face unbridgeable divides on
politics, religion and culture, do we need to add investing to the mix? If
you stayed with your Tesla investment, I wish you the best, and I hope
that you are holding on for the right reasons. If you sold short and lost
money, I get no joy out of your losses and no inclination to do a
celebratory dance.
¨ Not worth losing sleep over: As far as I am concerned, Tesla is a
fascinating company, but it is just an investment, not a matter of life or
death, and definitely not worth losing sleep and friends over.

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