EV Sector Deep Dive: A Framework for Valuing Electric Vehicle Stocks

TradingKey - The growth of the electric vehicle sector has turned EV stock investing into one of the most popular global equity market themes. The electrification trend, government policy backing, and technological advancements have created significant opportunities in the electric vehicle industry; however, the industry is also very speculative and has many stocks with volatile valuations.

In order to evaluate an EV stock correctly, investors must use a specialized evaluation framework that is different from most traditional stock metrics or analytical tools available.

Understanding the EV Vertical

The first step in evaluating any EV stock is to understand where that company fits within the larger electric vehicle market. The electric vehicle market does not only consist of electric vehicle manufacturers, but also encompasses many interconnected segments throughout the entire EV value chain.

Historically, these segments have included, but are not limited to, electric vehicle manufacturers producing vehicles, battery and component manufacturers who provide power systems for EVs, charging infrastructure manufacturers that help to construct the networks needed to support EV adoption and companies that provide the raw materials (such as lithium, nickel, etc.) necessary for the components that power electric vehicles. Each one of these segments operates under a different set of economics and risk characteristics.

For example, the valuation of an electric vehicle manufacturer is primarily driven by the production capacity of that manufacturer as well as the actual demand for their vehicles. Conversely, the revenues of a battery manufacturer are subject to fewer fluctuations, as most battery manufacturers generate the majority of their revenue through long-term supply agreements with electric vehicle manufacturers. Understanding these distinctions will assist investors in making comparisons between companies with similar characteristics and comparable expectations.

Essential Financial Indicators for an Electric Vehicle Manufacturer

Due to the variable nature of forward-looking/revenue-based valuation techniques for electric vehicle (EV) companies, as many remain in their growth cycle and have yet to produce earnings, traditional valuation methods (e.g., price-to-earnings ratio) may not have as much significance in these situations.

Given the absence of current earnings, one of the most prevalent methods for valuing EV companies is through the use of price-to-sales (P/S) ratio that assesses how much an investor is willing to pay for $1.00 of sales generated by an EV company. Discounted cash flow models are also utilized to estimate the value of an EV manufacturer based on forward estimates of free cash flow from increasing production capacity over time.

Measured gross margin per vehicle sold is a key performance indicator of the electric vehicle manufacturer. It represents the gross profit earned on each vehicle sold by the manufacturer, not including general and administrative (G&A) costs. When an EV manufacturer loses money on every vehicle produced, then it will have a difficult time achieving sustainable profitability unless it finds a way to significantly reduce costs.

Liquidity measures also play a vital role for early stage electric vehicle manufacturers. Investors are acutely aware of liquidity measures such as cash utilization or cash "burn" when assessing an electric vehicle manufacturer's ability to remain a viable company without additional sources of debt or equity financing.

The Technological and Operational Advantages 

In addition to evaluating an EV stock based on financial performance, it is important to evaluate the operational capabilities and technology advantages of the company being considered. The success of the EV industry is not only due to the product being created, but also because the companies that are manufacturing those products can effectively scale the manufacturing process.

If you’re using a large EV manufacturer’s vehicle as an example, the majority of EV manufacturers face a significant hurdle when transitioning from producing prototype vehicles to introducing large-scale production—often called “production scaling.” In order to gain a competitive edge, companies using advanced methods of manufacturing, or possessing highly automated production systems, typically do so.

Companies that have become leaders in the technology space often create a lasting moat around their businesses. A battery’s chemical formulation, the software that controls its performance, the capabilities of its autonomous driving systems, and how well the company integrates all suppliers will set one EV company apart from another. Most companies with solid intellectual property and control over key components tend to have lower costs and less disruption when facing supply chain issues.

Government Policies and Macro Forces

EV Markets are heavily influenced by government policies. Subsidies, tax credits, and regulatory mandates can heavily influence EV demand and the profitability of EV makers.

For example, policies that provide tax breaks or require that EVs be produced in this country will create a large benefit to companies that meet the policy requirements and a large disadvantage to companies that have overseas supply chains.

When looking at an investment in an EV stock, investors must evaluate geopolitical factors, and environmental regulations as well as the rapidly changing, industry policy landscape.

In addition, the EV sector is influenced by things that influence the overall economy such as commodity prices, interest rates, and global supply chain disruptions for battery materials.

Challenges Facing Electric Vehicle Investment

The electric vehicle (EV) industry consists of many long-term growth prospects, however, investing in EV stocks carries inherent risks. Much of the industry contains significant amounts of capital to create EVs, thus very few companies generate positive profits, but are spending large sums of money to develop new EV technologies, develop new factories to manufacture EVs and developing battery supply chains.

Three of the most important are government regulatory changes that create or remove incentives to purchase EVs; supply chain interruptions related to obtaining materials needed to manufacture EV batteries; and the lack of infrastructure, such as certain charging stations for operating an EV.

Any of these challenges can impact the pace at which consumers buy EVs and can reduce the potential value of these companies.

An additional challenge for investors in EV stocks is stock valuation. Stock for many EV companies is priced based on expectations for future revenue growth. If a company’s stock is priced based on current expectations, then any change in either investor sentiment or macroeconomic conditions could challenge the company’s stock price.

The EV Market Will Continue to Grow and Improve

Many investors will want to invest in EVs, and they should look to diversify across the entire value chain. In addition to automakers, investors should consider battery manufacturing companies, suppliers of semiconductors, companies that manufacture charging systems, and suppliers of raw materials for electric vehicles.

The long-term success of investing in EVs depends on a company having three key attributes: scalable manufacturing, unit economics that are sustainable, and technological differentiation. Companies that have these three elements will be in a good position to transition from high growth startups to long-lasting leaders in their industry.

As the transition to electric vehicles continues to evolve, the EV sector will continue to attract investor dollars – but investors will have to conduct a disciplined analysis of what is genuine innovation versus speculation, while paying close attention to financial metrics and thoroughly understanding the ever-changing competitive landscape.