Elon Musk made a mistake.
On Aug. 11, Tesla (TSLA 0.15%) raised $1.8 billion, $300 million more than anticipated, through a junk-bond offering whose 5.30% yield was slightly higher than the initially estimated 5.25%. Musk's electric-vehicle company had planned to raise at least $1.5 billion to fund its manufacturing ramp-up for the new Model 3. In a nod to the risks inherent in a company that burned through $1.2 billion in the second quarter alone, S&P rated the bonds a "B," while Moody's assigned them a "B3" grade.
Both stock and debt are just another form of currency. Image source: Getty Images.
To many, the bond issuance was a resounding success. But I contend that Tesla could have, and should have, raised capital through a method it's used so many times before: traditional common stock.
Everything comes at a price -- especially money
We all know the old saying "There's no such thing as a free lunch."
This simple adage, as most of us come to find out, is excruciatingly true. High-paying jobs come with heaps of stress and time from our families. And 'free' stays at resorts bring with them pitches for cruises. It also applies to money. Which is why weighted average cost of capital (WACC) was created. As a way of calculating the cost of money for businesses. is the yield a company needs to pay, on average, to each of its security holders to fund operations. In other words, it represents the return a business must earn to meet the demands of its owners and creditors. More important, WACC is, by way of stock prices and bond yields, dictated by the market, as opposed to management.
We've all experienced a simple version of WACC anytime we've borrowed money. What WACC does is takes it a step further. Averaging out the estimated costs of each funding source based upon the weight that capital source has in its capital structure. On the whole, it represents the return a business must earn to meet the demands of its owners and creditors. More importantly, it is a product of rates dictated by the market, as opposed to managerial bureaucracies.
is the yield a company needs to pay, on average, to each of its security holders to fund operations. In other words, it represents the return a business must earn to meet the demands of its owners and creditors. More important, WACC is, by way of stock prices and bond yields, dictated by the market, as opposed to management. A company with a high stock price and low debt interest rates will have a low WACC. The opposite is true of a company with a low stock price and above-average debt interest rates.
Businesses can raise money from various sources, including common stock, secured debt, and unsecured debt. The smartest financial minds in the world know that there's a time and a place for all these choices. It all depends on the cost.
What would 10-year-old Elon Musk do with a lemonade stand?
Unless you've been living in a cave for the past 5 years, the reader is no doubt aware that Tesla is one of the highest-flying stocks in the market today. TSLA shares are up over 1,700% since their debut in 2010. And this upstart company that is moving heaven and earth to produce 500,000 cars in a year is worth more than General Motors ($60 billion market capitalization, to GM's $54 billion). The market is willing to pay such a high price for a piece of Elon Musk because it believes he's going to change the world.
He just might. But that doesn't change the fact that Tesla's shares trade at a lofty valuation. And a stock's valuation is basically the inverse of its cost of capital. High valuation = low cost of equity.
Imagine you own a lemonade stand. You've been doing well, and you've generated $100 in profits this summer. As would any other 10-year-old tycoon, you want to expand, perhaps to a bigger neighborhood. To do so costs, say, $500 (Ok, so it's an organic lemonade stand). Your older brother is happy to give you the cash, but only if you give him a whopping 50% stake in your lemonade stand.
In this example, your price-to-earnings ratio is 10 (50% ownership = $500, giving you a market capitalization of $1,000). The cost of equity is the inverse: 10%. Sounds OK, but you think you can do better.
The thing is, every entrepreneur generally has more than one way to fund a business. Instead of going to your big brother to expand your lemonade business, you could always hit up dear old Dad for a loan. Hoping to engender your entrepreneurial spirit further, he might even offer you the money interest-free. Of course, he'll want to be paid back before you buy a new bike with your lemonade profits. That's fine. Anything to avoid giving up half-ownership.
What a Fool believes
Tesla just issued debt with a 5.3% coupon. Put another way, one could say that Tesla issued a debt instrument with a P/E ratio of 18.7. Not bad, given that the market's P/E ratio sits around 24, and 30-year U.S. T-Bills yield 2.74%. A bond's yield is, and should be, lower than the market's. It has no hope of growing and bondholders exchange growth and profit potential for the safety of a guaranteed return.
Common stock is a sort of "equity bond." It's less safe but more lucrative. Its "yield" consists of both price increases and dividends. With Tesla's share price hovering around $350, just off its all-time high of $387, it seems impossible to argue that this bond sale is a good deal for Tesla. The P/E ratio of its stock is incalculable because Tesla has yet to make a profit.
Tesla's price-to-book ratio also comes in at 11.25, making it easy to argue that the market is more than happy to pay an astronomical premium for the company's physical assets.
One might think that astronomical earnings growth will save the day. Alas, even the most optimistic of analysts polled by S&P Global Market Intelligence thinks Tesla could earn $6 per share in fiscal 2019. Tesla's shares currently trade hands at ~ $360 -- for a "super forward P/E ratio" of 60.
Musk is a genius. But he should have issued stock. The interest rate on Tesla's newly minted $1.8 billion in debt is 5%. Which means that $95.4 million in interest payments will flow from Tesla's bank account every year. Not ideal, for a notoriously cashflow negative company. With a stock so in demand, and defiant of the laws of gravity, a company should do one thing and one thing only: give the people what they want.
