Understanding financial returns and risks is important for all companies. This involves calculating the return on equity based on the DuPont system and the constant growth stock valuation. Moreover, an evaluation can be conducted on the type of capital constraints exist in relation to market competition.
Return on Equity
Using the DuPont system, return on equity is calculated by
In the preceding formula, the numerator contains the elements of the DuPont system – profit margin, total asset turnover, and financial leverage – while the denominator contains the formulas for each of these elements. This value is presented as a percentage (Schaltegger, 2017). The data used for this calculation is based on Tesla’s most recent quarterly financial statements for 2019 (quarter 2). The return on equity value (based on the denominator only from the above equation) is shown below. All values used in the calculation are in USD billions and obtained from the company’s income statement and balance sheet (Morningstar, 2019b, 2019a).
Based on this calculation, at the end of the second quarter in 2019, the return on equity was -6.55%, suggesting that investors will not be earning a return on their investments.
Constant Growth Stock Valuation
The current stock price of Tesla is $242.39 (Morningstar, 2019c). The constant growth stock valuation is calculated using the Gordon Growth Model. This formula is
where P refers to the stock price, D refers to dividends paid, r refers to cost of equity or rate of return, and g refers to the growth rate. There were no dividends paid, so these can be estimated based on the current stock price. The estimated dividend is calculated by
where the variables from the Gordon Growth Model are replicated. The constant growth rate (g) is estimated to be 0.43% (NASDAQ, 2019). In this formula and the Gordon Growth Model, r is estimated using CAPM, as shown below.
where Rf is the risk-free rate (often based on the yield for a 90-day Treasury bond), B is the beta of the security, and Rm is the expected return of the market (Horngren, Harrison Jr., & Oliver, 2011). The risk-free rate (rf) is 1.94% (US Treasury, 2019). The beta (B) is 0.33 (Yahoo Finance, 2019). The expected return of the market (Rm) is determined by finding the average return of Tesla based on daily stock prices for 2019. This resulted in an expected return of -0.12%.
Essentially to calculate the Gordon Growth Model, the formulas have to be worked in reverse (third, second, then first). Therefore, the first is the CAPM. This is shown below.
Next is the estimated dividend, shown below.
Finally, the Gordon Growth Model results in
This suggests that the stock is overvalued by $1.43, which is relatively insignificant on a per share basis. However, investors with hundreds or thousands of shares would find this to be significant.
Capital Constraints
To compete in this industry,
companies must have high amounts of capital. Without capital, it is impossible
to obtain technology and talent needed to create vehicles. These constraints
can be analyzed through assessing the company’s balance sheet and income
statement to assess the capital structure of the company. For this type of
company, equity and leverage is used.
References
Horngren, C. T., Harrison Jr., W. T., & Oliver, M. S. (2011). Financial & Managerial Accounting (3rd ed.). Pearson Education, Inc.
Morningstar. (2019a). Tesla Quarterly Balance Sheet. Retrieved from Morningstar website: https://www.morningstar.com/stocks/xnas/tsla/financials
Morningstar. (2019b). Tesla Quarterly Income Statement. Retrieved from Morningstar website: https://www.morningstar.com/stocks/xnas/tsla/financials#
Morningstar. (2019c). Tesla Quote. Retrieved from Morningstar website: https://www.morningstar.com/stocks/xnas/tsla/quote
NASDAQ. (2019). Tesla. Retrieved from NASDAQ website: https://www.nasdaq.com/market-activity/stocks/tsla/earnings
Schaltegger, S. (2017). Contemporary Environmental Accounting. Routledge.
US Treasury. (2019). Daily Treasury Bill Rates Data. Retrieved from US Treasury website: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=billrates
Yahoo Finance. (2019). Tesla. Retrieved from Yahoo Finance website: https://finance.yahoo.com/quote/TSLA/
