We Don't Play The Price-Target Game
It's almost inevitable. Analysts asked about a stock for a financial TV show or newspaper story will give a price target. The simplicity of that single number is alluring, cutting through the market's clutter and ambiguity.
However, we at the Forecasts have developed a healthy skepticism of experts bearing price targets. First off, it doesn't take much experience to realize that target prices are usually wrong. Second, can you trust that analysts so keen on convincing you to buy a stock today will provide timely updates on that target price? And, more importantly, tell you when to sell?
Many, though not all, analysts base their price targets in large part on a company's perceived fundamental value — what the stock should be worth in a perfectly efficient market. For stocks with a history of paying dividends, that target price could be the present value of the stream of future dividends, a model long used to value stocks.
Another model involves calculating price targets by estimating future free cash flow, an exercise that forces investors to think like business owners. Every company generates cash flow, whether positive or negative. And every company — or asset, for that matter — has an intrinsic value. That value can be estimated by calculating the cash flows expected over the company's lifetime, after adjusting for risk and the time value of money. These adjustments leave us with the present value of future cash flows, which is important because $100 million generated this year is worth more than $100 million projected five years from now. This model works under the premise that the excess cash will eventually return to investors, such as through dividends or reinvestment in the company to sustain growth.
However, many of the underlying numbers used in analyst models rely on estimates. For cash flows valued into perpetuity, even a small change in a company's growth rate or discount rate (the cost of financing) can have a huge effect on the price target. Moreover, estimated cash flows may depend on specific events occurring in the future that must also be handicapped.
The many layers of uncertainty in stock-valuation models call the usefulness of price targets into question. Unfortunately, investors focused on the inevitability of the price target might ignore signs that a company's story is changing. Consider the case of BlackBerry ($10; BBRY). In April 2011, shares of the company then known as Research In Motion traded around $50 to $55 a share, while several prominent analysts gave price targets of $60 to $80. One year later, the shares had fallen below $15 after Blackberry lost a big chunk of the smartphone market to the iPhone. Models can make assumptions appear as certainties, giving investors a false sense of security.
We do not assign specific price targets for stocks. Instead, we review traditional valuation metrics (including price/earnings, price/sales, price/cash flow, price/book, and enterprise ratio), seeking stocks cheap relative to the broad market and to their own history and peers. We then consider growth expectations and market conditions in an attempt to select stocks capable of exceeding the current forecast. Ideally, the growth story will improve over time, pushing our stocks higher.