What a Tesla stock split does and doesn't refer to

Today, Tesla TSLA + 12.6% shares traded for the first time since its stock split 5-for-1 last Friday. Shares of the company rose $ 55.64, an increase of 12.6%, to $ 498.32, raising the company's market value to a record high.

Tesla announced a stock split on August 11th, and since that date its shares have increased 81%, while the S&P 500 is up 5%.

To put the Tesla stock split in context, with the goal of sorting out the Tesla stock split signals, and in this issue not indicating it, consider some key insights from behavioral finance.

Unlike the approach to conventional finance, which emphasizes that stock splits are primarily cosmetic changes without major financial implications, behavioral research has documented that stock splits tend to accentuate true after effects.

A typical company's shares that participate in a stock split, but not a reverse split, are associated with a positive abnormal return of about 8% over a period of twelve months after the split.

What's really interesting is that companies that choose to split their shares tend to find themselves targets of pessimistic earnings expectations from analysts. Just over a month ago, Tesla surprised analysts when it reported a second-quarter GAAP earnings per share of 50 cents, compared to analysts' expectations of a $ 1.06 loss. Tesla also surprised analysts with regard to revenue and free cash flow.

The general conclusion from behavioral finance research is that companies that announce a stock split tend to be less likely to have a decrease in future earnings than companies with similar market value and price-to-book ratios.

In short, the behavioral approach indicates that if we take the outside view of Tesla, which means that we focus on the reference class to which Tesla belongs, and then divide its shares, the company indicates that it is confident in its ability to make future profits that do not decline.

What Tesla's stock split doesn't indicate is that its shares are priced somewhat relative to the fundamentals. Analysts at Morgan Stanley and JP Morgan have been contacting investors for more than five years with target prices that match the core values. Reports from the end of last month from my team of analysts agree on one thing. Tesla's market value lies above its underlying value.

On July 28, 2020, Tesla's stock was trading at $ 1,476. At the time, Morgan Stanley analysts set a twelve-month target price of $ 1,050 for Tesla, based on a discounted cash flow assessment. One week ago, JP Morgan analysts set a base value for Tesla at $ 295 a share, with which they pegged the $ 325 target price for the end of December 2020.

Although both analysts agree that Tesla's shares are overvalued, it is clear that they have very different views of their underlying value. In this, they were not alone. After a stock split, the target price range for analysts covering Tesla ranges from $ 17.40 to $ 500, with the average target price being $ 295.

Few analysts use discounted cash flow to reach target prices. Even JP Morgan analysts set a Tesla target price above their estimate of the fundamental value. This is in line with the behavioral approach that assumes that due to sentiment, market prices and core values ​​can divide the company for long periods of time, with the gap between the two being large and reasonably widening before narrowing it down.

The gaps between market prices and fundamental values ​​can be particularly wide for stocks with high experimental sentiment. Beta Sentiment reflects sensitivity to general market sentiment in the same way that the traditional beta reflects sensitivity to market return.

One of the most important features of highly emotional stocks is that these stocks are highly volatile, difficult to evaluate, difficult to arbitrage, and associated with small and low-profit companies. Not surprisingly, Tesla's stock qualifies as a highly emotional bet.

Short selling highly sentimental beta stocks is a risky business, even when it appears that these stocks are grossly overvalued on fundamentals. This is one of the key lessons I teach investors in my book, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing, which was published two decades ago. This lesson has not changed. However, for psychological reasons, it appears that many investors need to learn this lesson the hard way.

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