Let’s say that next year Tesla manages $50 million in profit. For the next 20 years the company grows at a high rate and then by 5% annually after that. Using a discount rate of 7% this high growth rate needs to be about 18% to fairly value the stock at the current market price.
I don’t know how fast Tesla Motors Inc (NASDAQ:TSLA) will grow 12 years from now. No one does. In order to justify the current valuation you have to make some pretty bold assumptions. And because the calculation is so sensitive to those assumptions the answer has little meaning at all. If the growth rate is dropped to 15% instead of 18% the value of the company falls by nearly 40%. If you’re wrong by 3% the company goes from being fairly valued to being outrageously overvalued.
The fact that you can tweak the parameters slightly and obtain a completely different result should tell you that the result doesn’t carry much meaning. When an analyst comes out with a price target this is exactly what they do. They tweak things until the answer comes out “right”.
A fuzzy future
Both Facebook Inc (NASDAQ:FB) and Tesla Motors Inc (NASDAQ:TSLA) pose a problem for investors – the future of both companies is unpredictable. Facebook is still trying to figure out how to monetize its enormous user base, and with young people increasingly ditching the site for alternatives like Twitter the company may have trouble growing its user base going forward. Is it possible for Facebook to grow its earnings by 30% per year? Sure. Do I have any confidence at all that the company will actually achieve this? Absolutely not. This is why doing a DCF calculation for Facebook Inc (NASDAQ:FB) is almost useless.
I don’t know what Facebook will look like as a company 10 years from now, so why would I invest in it? Will its profits come mainly from advertising, or will the company transform into something else entirely? Will users stick with Facebook, or will an alternative draw people away? These questions make valuing Facebook Inc (NASDAQ:FB) very difficult.
Tesla Motors Inc (NASDAQ:TSLA) has the same type of problem. The electric car market right now is tiny, but once it reaches a critical mass there will be a lot more competition than there is today. Is there anything truly unique about Tesla which suggests that the company will become a major car maker 20 years from now? Not really. The auto industry is extremely capital intensive and Tesla will struggle to scale up its operations as the market grows. If the company ever manages to produce a mainstream car it will likely face a slew of lower-cost competition from the the major auto companies. I don’t think Tesla will be meaningfully profitable for quite some time, and the growth necessary to justify its current valuation is just not realistic.
There is a chance, however slight, that Tesla Motors Inc (NASDAQ:TSLA) grows into a behemoth which dominates the electric car market. But the price you’re paying for the shares today seems to assume that this is a foregone conclusion instead of a low-probability outcome. The odds are not in the favor of the Tesla investor.
The bottom line
The biggest danger with a DCF calculation is trusting the results too much. Many people have an opinion going into it and then tweak the parameters so that the answer matches that opinion. Whenever someone claims that a stock is worth some amount based on a discounted cash flow calculation, make sure that the inputs make sense. If they don’t, then the “value” calculated is meaningless. Garbage in, garbage out.
The article Be Careful With Discounted Cash Flows originally appeared on Fool.com and is written by Timothy Green.
Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Facebook and Tesla Motors (NASDAQ:TSLA) . The Motley Fool owns shares of Facebook and Tesla Motors. Timothy is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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