- The size of the car market is not large enough to justify Tesla’s valuation
- That’s okay, because it’s big opportunity is probably not selling cars
- The idea of a car company that isn’t a car company is confusing for investors
- Loads of new idea generating data
Recently, a lot of companies seem to be harking on about the estimated size of their end markets. This can be a toppy sign that suggests investors are happy to be sold an overly optimistic view of the future.
By definition, few companies can capture a significant share of a market. What’s more, the amount of profit generated from the share they do capture is always uncertain. This can be particularly true in hot markets that have limited barriers to entry and lots of heavy-spending companies competing for the same prize.
Some interesting research from Research Affiliates ably made this point recently with reference to the electric vehicle (EV) market. One of the issues raised is that it is very hard to justify the valuation of Tesla (TSLA) based on total EV market size. “Tesla accounted for about 75 per cent of the total EV group’s market value and 35 per cent of the market value of the entire auto industry. Such an immense market capitalisation makes sense only if the expectation is that Tesla will come to dominate the entire auto industry, not just the EV market.”
While the researchers argued this could be a sign of delusion, there is actually a whole other way to look at this when it comes to Tesla; the Baillie Gifford way, if you like. And the counterpoint is a great illustration of why it is so hard to value disruptive companies. The fund manager argues Tesla is better perceived as a software company than a car company. The market cap suggests it is not alone in this view. Research Affiliates also tacitly acknowledges the possibility in a footnote to its research.
The point here is that a software company, such as Adobe, let’s say, does not need to worry too much about the size of the low-margin PC market as long as there are enough computers to comfortably go round. It’s chief concern is the number of high-margin software subscriptions it sells to individuals to use on computers.
On the basis that Tesla’s ultimate goal is to sell autonomous-vehicle software, the company should actually benefit from the market for cars shrinking. Indeed, the idea that it is in Tesla’s best interest to shrink the car market is one way to interpret its attempts to get ever more miles out of its cars by reducing components per vehicle and increasing battery life. Tesla model S, for example, claims to be able to do about 1m miles without a battery change; about five times what one can expect from the average gas guzzler.
Why does Tesla-the-software-company benefit from a smaller EV market? For the simple reason that it means it costs less to install and maintain the necessary hardware (computerised electric vehicles) on which its self-driving software will run. What’s more, in a world of self-driving cars, 'hardware' can be shared by users – cars pull up when needed rather than being parked on a driveway doing nothing. This would further limit the need for vehicles while undermining the logic of direct ownership. Meanwhile, running high-margin software in other manufacturers’ vehicles would offer a capital-light way to grow.
There may be obstacles to realising this self-driving future, but the sheer amount of money being spent suggests good odds that it will eventually happen. So the easy counter to comparisons between Tesla’s valuation and the size of the EV market is: 'wrong market, mate'.
In fact, in a self-driving future, the companies that have most to fear about the ultimate size of the EV market may be the traditional manufacturers that are pouring money into the inherently low-margin activity of making cars without also making huge investments in software. The software race may have been lost a long time ago for traditional manufacturers.
Whether the software company argument can justify Tesla’s valuation is another matter. One thing is for sure, though, having to entertain the counter-intuitive idea of a car company that isn’t a car company doesn’t half make life confusing for investors.
While portfolio disclosure delays means the accompanying list of fund managers’ favourite international shares does not fully reflect recent market ructions, we can see Tesla remains popular with top-performing funds.