• Tesla expected to report sharp decline in earnings for Q3

• Valuation is still stretched, leaving stock price vulnerable

• Earnings to be released after market close on October 18

Tesla slashes prices

For most of this year, Tesla has been cutting the price of its vehicles in an attempt to stimulate demand. The company also slashed the price of its premium driver assistance software for similar reasons.

Demand for Tesla cars has struggled amid growing competition from Chinese producers, who are increasingly taking market share in the electric vehicle space. High interest rates have also made it more difficult for consumers to get new auto loans.

Prices for the affordable Model 3 have come down nearly 17% this year, while editions like the long-range Model Y have seen price declines of over 25%. But despite these tremendous discounts, car deliveries still fell short of Wall Street expectations in the third quarter.

The company blamed some planned factory shutdowns for this shortfall, but in reality, high inventory levels amid subdued demand probably played a role as well.

Price cuts squeeze margins 

With the company selling its products for lower prices, it seems that sales received a boost, at the expense of profits. In the third quarter, analysts expect Tesla to report a revenue increase of 12.8% from the same quarter last year.

But earnings are expected to have declined by more than 29% over the same period. Hence, while the price cuts seem to have helped Tesla juice up its sales, they have also eaten into profit margins. 

One can argue Tesla was forced into this situation because of the unfolding ‘electric vehicle wars’. Either way, profits are going in the wrong direction and the competition is unlikely to relent anytime soon.

The market reaction will depend on whether earnings exceed or miss analyst forecasts, and on any commentary about the future outlook. Tesla has a history of exceeding analyst estimates, having done so in 7 of the last 8 quarters. Considering how low the bar has been set this time, it might be relatively easy for Tesla to report above-expectations figures again.

If so, that might help boost its share price. Looking at the charts, the most important region to watch on the upside is the recent high of 279.00, while on the downside, the spotlight would probably fall on the 235.00 region.

Valuation doesn’t reflect risks 

As always, the elephant in the room is Tesla’s exorbitant valuation. The carmaker’s shares are currently trading for almost 64 times what analysts expect earnings to be next year, and that is under the assumption that earnings are going to rise by 30% next year.

That is a wild valuation. Any stock that trades for 64 times next year’s earnings is either growing earnings at an impressive pace or is simply overvalued. Tesla seems to fall in the second category, since its earnings are in freefall.

And the assumption by analysts that earnings will grow 30% next year is highly suspicious. The electric vehicle price war is unlikely to dissipate so soon and there are no guarantees Tesla will be the winner. Additionally, such tremendous earnings growth seems unrealistic heading into a global economic slowdown, particularly in Europe and China.

Most likely, analysts are incorporating future growth opportunities into their models, such as Tesla licensing its driverless AI technology to other traditional carmakers. The problem is that these projects are not running yet, and might never come to fruition.

In short, there’s heightened risk around the company and its earnings outlook, which the rosy valuation doesn’t seem to reflect. This leaves Tesla vulnerable to a selloff, as elevated bond yields could eventually compress valuations.