BYD’s rise challenges Tesla—and its valuation

BYD’s Hong Kong-listed shares fell 6% Wednesday following the publication of its annual report, giving it a market value equivalent to roughly $86 billion, or 15 times forward earnings. The company had released preliminary sales and profit estimates in January, so there weren’t big headline surprises, but the final numbers were slightly lower than analysts expected. That plays into fears that China’s EV price war is sapping the market leader’s potential for profit growth as lower margins offset gains from shipping more vehicles.

The Chinese vehicle market remains highly promotional. There were price cuts on 25 models in February and a further 23 in March, according to a recent blog post by Cui Dongshu, secretary-general of the China Passenger Car Association—“an astonishing level from a historical perspective," he wrote.

Tesla, which has a market value of $566 billion or 62 times forward earnings, is exposed too. China accounted for 22% of its revenues last year. It cut prices in the country in early January and has since introduced discounts on insurance and financing. Even so, its Chinese sales this year are trending lower year over year, while inventories have risen. The company reduced output at its Shanghai plant earlier this month, according to Bloomberg.

BYD, which made headlines by overtaking Tesla in terms of total EV deliveries last quarter, is now catching up financially. Analysts expect both companies to report revenues of about $109 billion for this year. The difference is that the Chinese company sells more vehicles, including plug-in hybrids, at lower prices. This makes for lower margins and profit at BYD, but its growth prospects are probably stronger as the shift to EVs spreads beyond the price-insensitive early-adopter phase that rewarded Tesla.

The Chinese company hopes to offset the impact of price cuts on profitability by selling more premium vehicles in its home market—potentially taking share from Tesla as well as the German giants of the internal combustion engine—and by expanding abroad. Conversely, Tesla’s big growth hope is its more affordable “Model 2," which will likely dilute its margins after it comes out, currently expected to be next year.

Given that the companies are similar in scale, with BYD’s lower profitability arguably balanced by better growth prospects, why is Tesla’s market value on a totally different plane?

The only possible explanation is the hope that Tesla, after years of missed deadlines, might finally crack the code to vehicle autonomy. The company’s guidance has long included a line about hardware profit being “accompanied by an acceleration of AI, software and fleet-based profits," as the latest version reads. This is the sort of high-margin, capital-light business that just might justify a big-tech valuation—if it ever emerges, and if consumers pay for it.

Tesla’s “full-self-driving" software, which can drive its EVs in most situations but requires constant human supervision, has been getting more attention since the company started to roll out “version 12" late last year. This leans more heavily on artificial intelligence than the more coding-reliant version 11, potentially accelerating the pace of development. Musk seems to have decided it is time to drum up business: Overnight on Monday he said on his social-media platform X that all U.S. Teslas capable of delivering FSD would get a free one-month trial. Tesla charges either a one-time fee of $12,000 or $199 a month for FSD.

The news lifted the stock roughly 3% Tuesday, though it is still down 28% this year as the company’s sales have stalled. Much of the promise of FSD is related to Tesla’s growth: The more vehicles it sells, the more customers it has to sell FSD subscriptions to.

Automated driving technology is gradually improving, but it remains highly uncertain whether it can generate anything like the value for Tesla that investors appear to expect. A subscription of $199 a month is expensive for a product that still requires drivers to keep their eyes on the road, particularly as industry supplier Mobileye is starting to integrate similar technology into other premium brands such as Porsche and Polestar.

BYD itself launched a new vehicle software strategy in January, but it is still valued as an automaker. Its rise, and the comparatively modest valuation attached to it, is a challenge not just to Tesla, but also to investors who still think Musk’s carmaker deserves a place among the Magnificent Seven.

Write to Stephen Wilmot at stephen.wilmot@wsj.com