Elon Musk is a genius and his brainchild Tesla Motors Inc (NASDAQ:TSLA) is a brilliant company.
But with that said, we see this as a terrible time to invest capital in shares of TSLA. The potential reward simply isn’t worth the risk, and the potential to invest at a cheaper price is something we would be much more interested in.
An Extreme Valuation At a Time When Valuations Are Contracting
Tesla Motors is a well-loved and heavily owned growth stock. Which is great during times when growth stocks are in vogue.
As a “high-beta” stock (one that moves more quickly than the broad market), institutional managers can add exposure to TSLA to help them keep up with (or beat) benchmarks.
But unfortunately, when these same managers begin to worry about the risks of a falling market, growth stocks can be high on their list of sell candidates.
This danger has us worried about the potential for TSLA to drop quickly over the next few months – even though the company has a bright future and should do very well long-term.
Falling Estimates and Contacting Multiples
One of the most dangerous situations for growth stock investors is a situation where analysts are lowering estimates for earnings, while investors are becoming less risk tolerant.
In this case, the two forces together can have a compound effect that drives shares lower – much lower than just the percentage decline in earnings estimates.
For example, consider a company with projected earnings of $5.00 per share, with investors that are willing to pay 50 times earnings for. Obviously, the stock would trade at $250 per share.
Now, what happens when analysts cut their estimates by 40%? Will the stock drop 40% as well? (to $150?)
With falling expectations, investors will no longer be willing to pay such a high valuation for the company. So instead of 50 times earnings, investors might now only be willing to pay a multiple of 30.
The end result is a stock that trades for 30 times an estimated $3.00 of earnings – or $90. That’s a 64% decline in the stock price from just a 40% cut in earnings estimates.
Getting back to Tesla, Wall Street analysts have been revising their 2016 estimates lower (as shown in the table below). While this doesn’t mean the company will be unsuccessful – in fact, it may point to much more success down the road if Tesla is investing toward future growth instead of churning out short-term gains – it may very well mean that some investors will lose patience.
Notice that three months ago, analysts were expecting the company to earn $3.41 per share next year. But today, those estimates have been cut to $2.44.
If we are entering a period in which investors are becoming more conservative with their investments, we could see the valuation for Tesla contract significantly.
Unfortunately, this isn’t a popular view when it comes to “true believer” investors. We recently wrote a similar piece on the potential for Netflix Inc. to trade lower. Not surprisingly, we were buffered by irate comments from investors who couldn’t understand why we would have a bearish perspective on such a great company.
Of course it’s not our intention to speak ill of a great company like Tesla (or Netflix). Instead, we’re just trying to warn investors of what could happen (and determine the best way to profit from a likely scenario).
Potential Income In the Event of a Decline
Speaking of profit opportunities, we believe that if Tesla were to decline significantly, that the stock would be a great buy. But rather than buy shares outright, we would prefer to use an income approach to profiting from this company.
Our strategy of selling puts on stocks that we would like to own is perfect for this scenario.
If shares of TSLA were to fall sharply – say to $180 where they traded at the end of the first quarter, option premiums would quickly shoot higher. This is because higher volatility gives option buyers more opportunity to make large gains from moves in the underlying stock.
With higher option prices, we can collect more income from selling put contracts. And buy selling these put contracts we will be agreeing to buy shares of TSLA at a lower price point.
If TSLA trades higher from this level, we will get to keep the income we received from selling the put contracts (income which should be relatively lucrative because of the higher option prices).
And if TSLA continues to trade lower, we’ll be required to buy shares. But our buy price will be well below today’s optimistic price for the company and we will have already collected income from selling put contracts to begin with.
This is just one of the strategies we employ in our MTI Pro trading service. Our goal with this service is to create reliable income using strategies like this, while strictly limiting risk to our capital.
For now, we’re content to be patient with TSLA, choosing not to pay the market’s premium price, and waiting to see if we will have an opportunity to generate income from this great company – while taking on less risk.
Don’t be late to the party – Click Here to see what 4500 Wall Street Analysts say about your stocks.