Owners of Tesla (NASDAQ: TSLA) stock are probably thrilled with their investment in the electric car manufacturer. After all, its share price has risen by nearly 750% over the past 12 months! That’s an incredible rate of growth to the point where it becomes questionable in my mind. Tesla’s stock might be a classic case of a market bubble getting ready to burst, so let’s take a closer look.
What caused Tesla stock to surge?
Late last year, Tesla became the sixth-largest member of the S&P 500. The announcement was made on November 16, and the share price skyrocketed. But why? Because Tesla is now part of the index, all S&P 500 index tracker funds are forced to buy the stock. Thus Tesla’s price is pushed further.
Today the market capitalisation of the firm is nearly $770bn. That’s more than the market caps of Subaru, Nissan, Ford, Fiat, Honda, BMW, General Motors, Daimler (Mercedes-Benz), Volkswagen, and Toyota combined.
Tesla is definitely more than just a car manufacturer. But that doesn’t change the fact that its net income for the first three quarters of 2020 was only $420m, making its P/E ratio 1,833! In other words, at the current price, investors are paying $1,833 for every $1 of earnings – that looks like a very unsustainable valuation to me.
What would cause the bubble to burst?
As I understand it, the catalyst for the surge in share price is the stock’s inclusion in the S&P 500.
As the share price began to rise, institutional investors started buying shares to profit from the situation. This, combined with the incoming US administration pursuing a green revolution, makes Tesla look very appealing as a business. Perhaps FOMO (fear-of-missing-out) kicked in too. More investors started buying the stock, pushing its share price even higher to today’s valuation. At least, that’s my opinion of what has happened. If this is the case, then I think the share price could plummet in the coming weeks or months.
Historically, any boost in the share price of a stock that enters an index unwinds within 20 to 45 days. Why? Because most tracker fund managers rebalance their portfolios every month. Don’t forget these funds aim to hold an equal proportion of every company in the index.
As Tesla’s stock has risen so much so quickly, I think an institutional sell-off is likely to come very soon. And this may be enough to spook investors, bursting the $770bn bubble.
Tesla stock: market bubble or not?
Tesla is an up-and-coming business that continues to innovate with new technology to improve the world. It’s a company I’d certainly be proud to own. However, to me, the valuation is borderline insane. Therefore, in my eyes, Tesla is a case of ‘great business, bad stock’.
I believe current shareholders are going to be in for a rough ride very soon. And when that happens, I’ll be ready to start buying the shares. But for now, I’ll steer clear and look for investment opportunities elsewhere.