Tesla’s growth problem—by the numbers

After an incredible run, investors give Tesla a market cap bigger that's bigger than all automakers, save Toyota.

The good news for investors looking to jump on the Tesla train, and join the biggest momentum play in recent history, is that the price dropped by 17.2% on Wednesday, making Elon Musk’s phenom $27.3 billion cheaper in a single day.

The bad news is that Tesla’s market cap, as of Wednesday’s close, stands at $132.4 billion. (That was before Thursday’s open, in which it climbed by a mere 3%.)

Tesla’s valuation—despite Wednesday’s big selloff, it’s tripled since early October— is the crucial metric in handicapping whether it’s a good or bad investment from here. Why?

Because taking its market cap as a starting point allows you shut out what Tesla’s fans expect it will deliver, and focus on what it must deliver to reward shareholders. Tesla’s gigantic market cap establishes the starting bar that in turn dictates the height of all future bars it must surmount to deliver a decent return. And since the starting bar was already lofty a year ago, and has tripled in height since, Tesla will need an Olympian pole vault of a jump, the kind usually achieved only by the best of tech, to reach those heights.

In 2019, Tesla surprised Wall Street by delivering $872 million in free cash flow—defined as cash from operations less investments in plant and equipment. That’s up from a negative $222 million in 2018, and a deficit of $4.1 billion in 2017. Hence, Tesla is now selling for 152 times last year’s free cash flow (the $132.4 billion market cap divided by $872 million in FCF)—the very dollars needed for, say, dividends, buybacks, or to invest in operations for expanding or streamlining production.

Buckle up, investors

Tesla is a risky stock, to put it mildly. So let’s assume that its shareholders would want at least a 10% annual return. Who would want to be strapped into Tesla, careening around mountain curves, for less?

Here’s a model showing the cash flow trajectory that would get Tesla to that 10% annual benchmark over the next ten years. We’ll assume Tesla pays no dividends, and doesn’t buy back stock, since it’s likely that given Musk’s supreme confidence in his model, he’ll plough back all of his cash flow to grow his creation. So 100% of the gains would come from a growth in the stock price. We’ll also assume that Tesla’s big growth sprint lasts through 2029, and that thereafter it no longer generates outsize returns on its re-invested earnings—the normal life cycle for fast-growing companies.

In our model, the price of Tesla’s shares would need to rise 159% by the end of our target period in February, 2030. But getting there requires its total market cap to wax even more, because it’s likely that Tesla will have a lot more shares outstanding via grants to employees, and perhaps dilutive acquisitions. We’ll use a conservative estimate that the float will be 12% bigger in early 2030. So growing its share price by 159% over those ten years dictates that its overall valuation rise by 12% more, or 178%, to compensate for the higher share count. Hitting the 10%-a-year target requires that Tesla’s market cap jump to 178%, or nearly triple, to $368 billion in ten years.

Explore: Fortune’s Q1 2020 quarterly investment guide

What size cash flow would get Tesla to a valuation of $368 billion? Let’s project that Tesla will remain a glamour stock in early 2030, commanding a premium multiple of 20 times FCF. That math requires that its FCF jump from last year’s $872 million, to $18.4 billion (its $368 billion market cap divided by its multiple of 20).

Increasing cashflow from $872 million to $18.4 billion—a 21-fold jump— in a decade would would require average annual increases of 36% a year. That’s like adding 85% in FCF every two years.

If Tesla proves extremely profitable by carmaker standards and generates 15% pre-tax (and 12% after-tax) free cash flow returns on sales, its annual revenues would need to hit $153 billion in early 2030. Getting there would entail increasing 2019 sales ($24.6 billion) more than six-fold.

The rub is that Tesla would need to gobble up a gigantic proportion of tomorrow’s passenger car market. Last year, it sold 367,000 autos at an average price of $57,000. But Tesla is targeting the mass market with its lower-priced Model 3. It’s hard to predict the average price for a Tesla ten years hence, but if we project a mix dominated by its lower priced models, a reasonable estimate might be in the $50,000 range. At that price, Tesla would need to sell 3.1 million autos by the start of 2030. That’s 2.7 million more than it sold in 2019.

How big is that number as a share of the projected growth of the total world market, and Tesla’s target audience? IHS predicts that global light vehicle sales will expand from 95 million in 2019 to 110 million in 2026, the end of its forecast period. If we project that sales increase at the 2% annual rate IHS posits for the end of that period, sales would hit 120 million by early 2030, for a total increase of 25 million from 2019.

It’s a sure bet that far less than half of that increase will come in the Tesla’s relatively high-priced sweetspot. It’s likely that all Tesla cars would sell for more than $40,000 in 2029. (The average price for a light vehicle today is $27,000). But even if we make a generous prediction that 40%, or 10 million of the market’s growth comes in cars costing $40,000 or more, Tesla would by early 2030, need to be capturing close to 30% of the entire increase in the upper four-tenths of the world’s light vehicle market. Taking that huge slice of the growth pie would force Daimler-Benz, Volkswagen, Ford, GM and sundry rivals to battle over the shrunken portion that’s left. Those competitors will battle back with their own electric cars and bargain to slow Tesla’s rise.

You’ve got to buy a lot of big, Tesla-positive predictions on volumes, margins, and weak response from competitors to believe that it will take that much of tomorrow’s market, the essential for rewarding investors from here.

Miracle stocks are common in tech, but Tesla is operating in the generally dreary business of cars. The math is likely to puncture the miracle.

On the other hand, Tesla could prove a thriving carmaker, and its stock could still perform poorly. The good-company/poor-investment scenario is more likely than the bull case for its shares.

Tesla’s fans are to blame for its probable failure as an investment from these heights. Their exuberance has set the bar too high for their hero’s stock to vault to glory.

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