If Tesla won’t own the world, consider selling your Tesla shares.

In recent trading, the market cap of Tesla reached $869 billion.

If you own Tesla, this high market cap is good news. But if you plan to keep Tesla stock, this astronomical market cap may, in fact, be bad news.

If you, or clients, have big gains, you might not want to sell and incur capital gains tax. If you want to skip the discussion of Tesla, jump right here to request your free copy of our Sterling Advisor Guide: Concentrated Stock Positions.

But if you’re interested in learning more about why Tesla’s $869 billion market may be bad news, read on.

The answer has everything to do with 1) value, and 2) volatility. If the value is not justified, there might be more downside than upside.

Value

The value argument is fairly straightforward. At an $869 billion market cap, the market is valuing Tesla at MORE THAN the sum of all these 12 car companies:

• Toyota
• Porsche
• Mercedes-Benz
• BMW
• Volkswagen
• Ford
• General Motors
• Honda
• Hyundai
• Kia
• Nissan
• Subaru

In the most recent year, Tesla reported earnings of $13 billion. That means Tesla trades at a price/earnings ratio of 66.

But consider that the combined earnings of the 12 other car companies was $145 billion!

Why is the market valuing Tesla’s $13 billion of earnings at more than these 12 other companies’ $145 billion?

The market represents the combined judgments of thousands or millions of investors and potential investors. We cannot pretend to know why the market does what it does. But here are two hypotheses.

The Musk Mystique

One hypothesis is what we’ll call the Musk Mystique. Whatever you might think of Elon Musk, whatever you might think of his politics, his personal life, or his business methods, there is no doubting that he is a genius of rare ability and accomplishment. Few, if any, other businessmen have built such a variety of huge businesses. And none has ever amassed the personal fortune that Musk has.

Given Musk’s track record of, seemingly, spinning straw into gold for shareholders, it seems plausible that there is a “Musk premium” built into the price of Tesla. Perhaps some investors believe that Musk will continue to be able to do the “impossible,” thus justifying the high value the market is placing on Tesla.

The Allure of Artificial Intelligence (AI)

Another hypothesis, perhaps a corollary of the first, is that the market is valuing Tesla as an AI company. For years, the promise of self-driving cars has captured the imagination of investors. And for years, Tesla has been promising that true self-driving cars are on the horizon, if not actually just around the corner.

With the current enthusiasm for AI, it seems plausible that Tesla is benefiting from the hope, belief, or expectation that true self-driving cars will propel Tesla to a market dominance that justifies the current price.

The Volatility Argument

Tesla stock has historically been extremely volatile. Historical annual standard deviation of returns on Tesla stock has been in the neighborhood of 57%.

For comparison, the long run volatility of the S&P 500 has averaged about 17.5%. That makes Tesla over three times as volatile as the market.

You might ask, so what?

Remember that we are trying to explain how the current value of $869 billion is a “fair” or “efficient” value.

The Efficient Market Hypothesis, as readers may recall, is the hypothesis that all available information is already reflected in the price of a stock.

Certainly, all the information that we have adduced above is well known to any investor who cares. That is, we cannot claim or assume that we know more than the market. The market knows about Musk, about the value of Tesla versus other car companies, about AI, and about Tesla’s volatility.

In the world of efficient markets, investors (on average) get paid for bearing risk. Risk is usually measured as standard deviation of returns.

In one version of the Efficient Market Hypothesis, the expected return on a stock is a linear function of the expected standard deviation of returns on that stock. Applying that to Tesla, a volatility of 3.25 times the volatility of the market implies that the expected return is also 3.25 times the expected return of the market.

The long run (compound) return on the S&P 500 has averaged about 10%.

Applying that to the above reasoning implies that the market “expects” Tesla to generate returns of approximately 32.5% annualized.

In other words, if the expected return to a stock is a function of the stock’s volatility, and the market price is the “efficient” price, the expected return to a stock with the volatility of Tesla is about 32.5%.

Are Such Returns Possible?

What would 32.5% annual growth, compounded, mean?

Suppose the growth is expected for six years. Tesla’s market cap would then grow to about $4.7 trillion after five years. That’s more than Apple’s market cap.

It’s not impossible. But it doesn’t seem very likely either.

If You Think It’s a Good Time to Sell Tesla

We don’t know if it’s a good time to sell Tesla. That might depend on how much Tesla you, or your clients, own.

With Tesla’s volatility, most advisors we’ve spoken with suggest that Tesla’s 1.6% of the S&P 500 seems about right as a target for a good portfolio weight to Tesla.

However, given Tesla’s tremendous long term performance, many investors have a much bigger position.

How to Avoid Capital Gains Tax

Reluctance to pay the capital gains tax on large gains makes some people hold even when they know they should sell.

For people who should sell, and don’t want to pay the capital gains tax, a good alternative is a tax-exempt Stock Diversification Trust.

A tax-exempt Stock Diversification Trust is easy and cost-effective to implement. The client transfers the stock to the trust. The trust then sells the stock, and because the trust is tax-exempt, there is not capital gains tax on the sale. You, the advisor, are then able to invest the entire pre-tax value of the stock into a diversified portfolio. The client, usually the client’s children, and often grandchildren, continue to benefit from the trust. In cases we see, the family will typically end up with over twice as much net, after-tax, spendable money by using a Stock Diversification Trust compared with selling the stock, paying tax, and reinvesting the proceeds.

To learn more, please call us at 703 437 9720 and ask for Connor or Katherine. Or request a copy of our Sterling Advisor Guide: Concentrated Stock Positions. This 31 page guide, available free, will walk you through nine common solutions, how each works, its benefits and limitations, and provides a convenient “Choosing a Solution” flowchart to help you select the best alternative for each client situation.