It has been a rough month for Tesla with the stock down almost 25 percent in recent weeks. Yet for all of the pain for Tesla shareholders, the company itself does not lose any money directly when its stock price falls. It’s worth asking then if Tesla or other companies care when their stock prices fall.
In some circumstances, stock prices obviously matter. For instance, virtually every oil company would be in better shape if their share prices were twice as high – it would allow the firms to raise more capital at a time when debt funding is somewhere between nearly impossible and completely impossible to access. Tesla (like most other firms) is not in this situation though.
Yet there is a still a strong case to be made that Tesla should care about its stock price. In particular, stock prices contribute to a firm’s cost of equity, which in turn is half of the cost of capital. Companies need to establish what their cost of capital is and then use that to guide them in picking appropriate projects and investments to make within the company. If a company ignores its cost of capital, it will quickly find itself locked out of both the equity and debt markets, and even more importantly, it becomes a takeover target for firms looking to optimize ROAs. Related:Are Subsidies Killing US Solar Companies?
In Tesla’s case this issue is particularly important. The firm is making several major investments, from the new Gigafactory to the Model 3. These investments need to have a high enough expected payoff to compensate investors and lenders for the risk they are taking in the firm’s stock and debt. The more volatile Tesla’s stock is, the higher the required return for investors becomes. Hence it is in Tesla’s best interest to get the volatility of its stock under control as best it can. Related: Goldman Sachs Is Now Bigger Than Exxon, Chevron in Nat Gas Trading
There are a number of ways the firm can try to minimize its volatility including better transparency, clarity on future cash needs and expected investment returns, and using various levers like analyst coverage and SEOs to influence investor type compositions. Minimizing volatility by using these tools could lower Tesla’s cost of capital by around 4 percent annually based on back of the envelope calculations. Thus there is an economic justification for Tesla to care about its stock price, and the case for that hypothesis is strong. Related: Holding 30% Of June Brent Crude Contracts, Is Glencore Manipulating Oil Prices?
That case is important because it is the driving force behind investor disclosure and executive commentary on quarterly conference calls. Without an incentive to keep stock prices high, it becomes very difficult to trust the motives of Tesla or any other firm’s management. As long as the company and shareholders both want to see share prices move higher, corporate harmony ensues. Without this alignment, investing becomes much more difficult.
With that said, while Tesla’s stock is out of favor at present, the company does represent a rarity in the current market – a company with substantial growth in sales. Most companies see EPS growth over time largely thanks to retained earnings. Yet growth in sales is often more elusive. That’s not the case for Tesla. And over time it is sales growth that drives the size and profitability of a company.
Granted Tesla still has a long way to go before it lives up to its valuation on a DCF standpoint, but historically valuations are generally not a significant determinant of stock returns on high growth stocks. Tesla is unlikely to be any different. The stock may be out of favor for now, but if the company takes smart long run actions that benefit its shareholders on the basis of quantitative metrics like WACC, then its stock will reap the benefits in the medium term.
By Michael McDonald of Oilprice.com
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