Investors should wait for these 2 signals before buying Tesla

Tesla's stock price might have fallen, but buying today does not guarantee good returns to investors.

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This article was originally published on All figures quoted in US dollars unless otherwise stated.

Most investors have their regrets. One of the most commonly heard regrets in the last few years is failing to buy Tesla (NASDAQ: TSLA) stock early on.

Many swear they will not miss the boat again if the market offers them another opportunity to buy Tesla stock, preferably during a stock correction. And with Tesla's stock down by around 30% (as of the time of writing) from its 12-month high, they are getting excited.

But investors should not rush into loading up on Tesla's stock, at least not until they see these two signals.

1. Evidence of sustainability of earnings

Tesla has been on fire lately.

After delivering its first profitable year in 2020, it ended 2021 with some mind-blowing numbers -- revenue surged 71% to $53.8 billion, and net profit jumped 665% to $5.5 billion. Tesla's strong performance continued in the first half of 2022 after it delivered even higher revenue and net profit. A marked turnaround if you consider that the vehicle manufacturer almost went bankrupt a few times, most recently just a few years ago .

On top of that, the EV race has continued to intensify, with incumbents -- General Motors and Ford -- and pure EV players -- like BYD -- eyeing shares in this growing industry. There is no guarantee that Tesla can sustain its market share in this ever-more-competitive environment. Even if it succeeds in defending or even growing its sales volume, there is a risk that it might need to reduce its pricing to remain competitive, which will impact its margins and, ultimately, profitability.

Still, I find it hard to ascertain whether Tesla can remain profitable given its short history of profitability. In the event of an economic downturn -- and we are seeing one coming quickly -- such profits could evaporate quickly. The U.S. government recently released its inflation rate for the 12 months ended June 2022, which hit an all-time high not seen since 1981.

There are two parts to stock investing. While finding a great company with durable earnings is paramount, it's equally important to buy its stock at a fair price. Overpaying for a stock reduces potential returns. Moreover, determining a company's actual value is not an exact science and isn't fairly straightforward. That means it's essential to have a margin of error, or in Ben Graham's words, a margin of safety. 

Tesla's bulls will immediately disagree with such a comparison since they view Tesla more as a technology company than an old-school vehicle maker. But even if we compare Tesla to a leading technology company such as Alphabet -- which has PS and PE ratios at 5.7 and 21.7, respectively -- the former's valuation is still unreasonably high. While everyone differs in their opinion on what constitutes a reasonable price, I will only consider Tesla when it trades at comparable multiples (or cheaper) to that of Alphabet. 

The high inflation will hit Tesla in numerous ways. One way is that inflation will reduce the discretionary income consumers spend on high-price items like cars. On top of that, an inflationary environment usually pushes interest rates higher, making it more expensive (and challenging) for average folks to get car loans -- pointing to a headwind for Tesla's EV sales in the coming months.

Long story short, I think investors need more confirmation on the sustainability of Tesla's profitability. That means waiting for at least a few more quarterly results before making their move.

2. Valuation needs to become affordable

So is Tesla stock trading at a fair price at the moment? My answer is probably not.

There are many ways to look at this. The easiest one is to compare Tesla's valuation ratios to those of its automobile peers, like GM. As of writing, Tesla has a price-to-sales (PS) ratio of 15.1, and a price-to-earnings (PE) ratio of 107.4. GM's ratios are 0.4 and 6.9, respectively.

Clearly, investors are still highly bullish on Tesla's long-term growth (even after the recent stock decline). However, from my experience, it's usually quite dangerous to buy a stock when growth expectations are too high since that would mean little margin for error for management.

Why investors should wait before buying Tesla

There is no doubt that Tesla is a great company. It came from nowhere and, over the years, became the leader in electric vehicles, potentially expanding heavily into mega sectors like renewable energy, robotaxis, and others.

But a great company is not necessarily an excellent investment. For it to become a solid investment, it must deliver sustainable profits over long periods. And investors should not overpay for the company.

All told, it makes sense to wait for a few more quarters to get more confirmation of its profitability's sustainability and potentially get a better entry point.

This article was originally published on All figures quoted in US dollars unless otherwise stated.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Lawrence Nga has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Tesla. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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