What Tesla’s Stock Split Does And Does Not Signal
Today, Tesla TSLA -0.9% stock traded for the first time since splitting 5-for-1 last Friday. The company’s shares rose by $55.64, a 12.6% increase, to $498.32, taking the company’s market capitalization to a record high.
Tesla announced the stock split on August 11, and since that date its shares have increased by 81%, while in contrast the S&P 500 increased by 5%.
To place Tesla’s stock split into context, with a view to sorting out what Tesla’s stock split signals, and for that matter does not signal, consider some key insights from behavioral finance.
In contrast to the approach in traditional finance, which emphasizes that stock splits are essentially cosmetic changes with no major financial impacts, behavioral research has documented that stock splits tend to feature real subsequent effects.
The shares of the typical firm that engages in a stock split, but not a reverse split, are associated with a positive abnormal return of about 8% over a twelve month period following the split.1
What is really interesting is that companies which choose to split their stocks tend to find themselves the objects of pessimistic earnings forecasts by analysts. Just over a month ago, Tesla surprised analysts when it announced second quarter GAAP earnings per share of 50 cents compared to analysts’ consensus forecast of a $1.06 loss. Tesla also surprised analysts in respect to revenues and free cash flow.
The general finding from behavioral finance research is that companies which announce stock splits tend to be much less likely to experience declines in future earnings than companies with comparable market capitalizations and price-to-book ratios.
In a nutshell, the behavioral approach indicates that if we take the outside view of Tesla, meaning that we focus on the reference class to which Tesla belongs, then by splitting its stock, the company is signaling that it is confident that it will be able to deliver future earnings that do not decline.
What Tesla’s stock split does not signal is that its shares are fairly priced relative to fundamentals. Analysts at Morgan Stanley and JP Morgan have been communicating to investors for more than five years target prices that correspond to fundamental values. The reports from the end of last month, from both analyst teams, agree on one thing. Tesla’s market value lies above its fundamental value.
On July 28, 2020, Tesla’s stock was trading at $1,476. At that time, Morgan Stanley analysts established a twelve month target price of $1,050 for Tesla, based entirely on a discounted cash flow valuation. One week earlier, JP Morgan analysts established a fundamental value for Tesla’s stock of $295 per share, which they related to a target price of $325 for the end of December 2020.
Although both analyst teams agreed that Tesla’s stock was overvalued, they clearly had very different views about its fundamental value. In this, they were not alone. Post stock split, the range of target prices for analysts covering Tesla is $17.40 to $500, with the median target price being $295. Remember, Tesla’s August 30 closing price was $498!
Few analysts use discounted cash flow to arrive at their target prices. Even JP Morgan’s analysts set a target price for Tesla above their estimate for fundamental value. This is in line with the behavioral approach which posits that because of sentiment, market prices and fundamental values can part company for long periods of time, with the gap between the two being large and plausibly widening before narrowing. In this regard, it is worth noting that according to Morgan Stanley’s valuation framework, 75% of Tesla’s fundamental value derives from Tesla’s free cash flow stream after 2030. New information about what is likely to occur after 2030 is scant relative to the volatility in Tesla’s current market price.
Gaps between market prices and fundamental values can be especially wide for stocks that feature high sentiment betas. Sentiment beta reflects sensitivity to general market sentiment in the same way that traditional beta reflects sensitivity to the return on the market.
One of the most important features of stocks that feature high sentiment beta is that these stocks are highly volatile, are difficult to value, are difficult to arbitrage, and are associated with companies that are young and while currently low in profitability have great profit potential. Not surprisingly, Tesla’s stock qualifies as featuring high sentiment beta.
Short selling high sentiment beta stocks is risky business, even when these stocks appear to be wildly overvalued on fundamentals. This is one of the main lessons I communicated to investors in my book Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing, published two decades ago. That lesson has not changed; however, for psychological reasons, many investors seem to need to learn that lesson the hard way.
Today, Tesla TSLA -0.9% stock traded for the first time since splitting 5-for-1 last Friday. The company’s shares rose by $55.64, a 12.6% increase, to $498.32, taking the company’s market capitalization to a record high.
Tesla announced the stock split on August 11, and since that date its shares have increased by 81%, while in contrast the S&P 500 increased by 5%.
To place Tesla’s stock split into context, with a view to sorting out what Tesla’s stock split signals, and for that matter does not signal, consider some key insights from behavioral finance.
In contrast to the approach in traditional finance, which emphasizes that stock splits are essentially cosmetic changes with no major financial impacts, behavioral research has documented that stock splits tend to feature real subsequent effects.
The shares of the typical firm that engages in a stock split, but not a reverse split, are associated with a positive abnormal return of about 8% over a twelve month period following the split.1
What is really interesting is that companies which choose to split their stocks tend to find themselves the objects of pessimistic earnings forecasts by analysts. Just over a month ago, Tesla surprised analysts when it announced second quarter GAAP earnings per share of 50 cents compared to analysts’ consensus forecast of a $1.06 loss. Tesla also surprised analysts in respect to revenues and free cash flow.
The general finding from behavioral finance research is that companies which announce stock splits tend to be much less likely to experience declines in future earnings than companies with comparable market capitalizations and price-to-book ratios.
In a nutshell, the behavioral approach indicates that if we take the outside view of Tesla, meaning that we focus on the reference class to which Tesla belongs, then by splitting its stock, the company is signaling that it is confident that it will be able to deliver future earnings that do not decline.
What Tesla’s stock split does not signal is that its shares are fairly priced relative to fundamentals. Analysts at Morgan Stanley and JP Morgan have been communicating to investors for more than five years target prices that correspond to fundamental values. The reports from the end of last month, from both analyst teams, agree on one thing. Tesla’s market value lies above its fundamental value.
On July 28, 2020, Tesla’s stock was trading at $1,476. At that time, Morgan Stanley analysts established a twelve month target price of $1,050 for Tesla, based entirely on a discounted cash flow valuation. One week earlier, JP Morgan analysts established a fundamental value for Tesla’s stock of $295 per share, which they related to a target price of $325 for the end of December 2020.
Although both analyst teams agreed that Tesla’s stock was overvalued, they clearly had very different views about its fundamental value. In this, they were not alone. Post stock split, the range of target prices for analysts covering Tesla is $17.40 to $500, with the median target price being $295. Remember, Tesla’s August 30 closing price was $498!
Few analysts use discounted cash flow to arrive at their target prices. Even JP Morgan’s analysts set a target price for Tesla above their estimate for fundamental value. This is in line with the behavioral approach which posits that because of sentiment, market prices and fundamental values can part company for long periods of time, with the gap between the two being large and plausibly widening before narrowing. In this regard, it is worth noting that according to Morgan Stanley’s valuation framework, 75% of Tesla’s fundamental value derives from Tesla’s free cash flow stream after 2030. New information about what is likely to occur after 2030 is scant relative to the volatility in Tesla’s current market price.
Gaps between market prices and fundamental values can be especially wide for stocks that feature high sentiment betas. Sentiment beta reflects sensitivity to general market sentiment in the same way that traditional beta reflects sensitivity to the return on the market.
One of the most important features of stocks that feature high sentiment beta is that these stocks are highly volatile, are difficult to value, are difficult to arbitrage, and are associated with companies that are young and while currently low in profitability have great profit potential. Not surprisingly, Tesla’s stock qualifies as featuring high sentiment beta.
Short selling high sentiment beta stocks is risky business, even when these stocks appear to be wildly overvalued on fundamentals. This is one of the main lessons I communicated to investors in my book Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing, published two decades ago. That lesson has not changed; however, for psychological reasons, many investors seem to need to learn that lesson the hard way.
