Valuing The Automotive Industry

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I would like to thank Rob Arnott, Richard Gerger, Andrew Cornell, Shaun Cornel and Aswath Damodaran for helpful comments.

An investor would have to have been living under a rock not to have noticed the appreciation in the value of automobile companies in the last two years. Tesla, of course, is the premier example. In less than two years, its market capitalization has soared from less than $100 billion to over $1.2 trillion at one point. But Tesla is hardly alone. Recent electric entrants like Xpeng, Nio, Rivian, and Lucid have all seen their valuations jump. Even traditional automakers like Ford, GM and Volkswagen saw their valuations rise when they announced electric vehicle plans.

This across-the-board run-up is sufficiently unprecedented that it calls for a valuation analysis of the automotive industry. Are the price increases consistent with reasonable fundamental valuation – for all companies in the industry or just a small group? What are the investment implications?

Before turning to the data and analysis, there is a key economic principle related to technological innovation and valuation that must be kept in mind. Specifically, a new technology does not translate into value creation for a company that adopts it unless it produces returns on invested capital (ROIC) in excess of the cost of capital. To earn excess returns, there must be barriers to entry that prevent competitors from adopting the technology, entering the business and driving down the ROIC to the cost of capital.