Do Wall Street stock price targets really matter? What investors need to know.

  • By Al Root,
  • Barron's
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When thinking about a stock, the question ultimately comes down to: What is it worth?

That’s what every Wall Street analyst tries to answer by giving a price target—or where the stock is expected to be in, typically, 12 months’ time—when preparing a research report on a particular company. Stock-price targets are quoted on television and cited in Barron’s and elsewhere.

Sometimes, the targets themselves are news, as in 1998, when Henry Blodget put a $400 target on then e-commerce upstart Amazon.com (AMZN). At the time, it was trading at about $240, but it hit Blodget’s target in just three weeks. More recently, J.P. Morgan analyst Stephen Tusa’s $10 price target on General Electric (GE) proved to be ahead of the market.

But a target may not always be so useful for stock-price forecasts. Many professional money managers say they’re skeptical that it’s anything more than a marketing tool for the brokerage industry to generate interest in a stock. Indeed, Barron’s found 28 stocks in the S&P 500 index (.SPX) with a Buy rating (or its equivalent) and a price target below current levels, including Deere (DE), Walmart (WMT), Costco (COST), and Abbott Laboratories (ABT).

For investors, the assumptions that underlie analysts’ price targets are not always obvious.

Take Cisco Systems (CSCO), a stock that is well liked by Wall Street. We talked to two analysts who cover the company. Both have Buy recommendations and similar price targets, but they differ in how they reached their valuation. (Barron’s agreed not to identify the analysts.)

The first analyst says he applied a 17 times price/earnings ratio on the company’s July 2020 fiscal-year earnings-per-share estimate, which is 30% above its historical average. The analyst contends that Cisco’s business model justifies the higher multiple, but doesn’t explain further.

The second analyst took a different approach, basing his price target on a blended P/E multiple by valuing the different business segments separately. He values Cisco’s software business at 25 times earnings, the services business at 16 times earnings, and the hardware business at 11 times earnings.

A basic P/E ratio and a more sophisticated ratio are just two of the myriad valuation approaches that analysts take. These can range from the very simple to the labyrinthine. And embedded in any methodology are assumptions that go unchecked unless an investor is willing to dig deep into a research report.

Other methods to reach a price target can include: a sum-of-the-parts analysis, discounted cash flow, mergers-and-acquisitions potential, expected value scenario planning, price-to-book value, replacement cost analysis, P/E, price-to-cash-flow, Ebitda (earnings before interest, taxes, depreciation, and amortization) multiples, sales multiples, and PEG (price/earnings to growth) ratios, among others. Investors should, at a minimum, understand how analysts derive their price target and, of course, what those terms actually mean.

Investors also need to decide whether price targets matter at all.

Take Cisco again. Among the 16 analysts who rate the shares a Buy, according to Bloomberg, the average price target is about $60—about 10% higher than recent trading levels. That may sound like an acceptable return for the tech giant until one realizes that Cisco’s price target is always 10% to 20% above where the stock is trading.

“We don’t pay any attention to sell-side price targets,” Arun Daniel, a senior fund manager manager at J O Hambro Capital Management Group, tells Barron’s. “We rely on our own valuation work.” (The sell side is the industry term for brokers like Goldman Sachs (GS) who “sell” research to the “buy” side. Money managers like Hambro buy Goldman’s research.) “I prefer to look at cash flows and return on invested capital,” he says.

Tony Scherrer, director of research at Smead Capital Management, says that while price targets don’t play a big role in his investment process, he does pay attention to the number of Buy and Sell ratings on a stock. Scherrer calls himself a value investor and wants to find “dollars trading for 50 cents.” When analysts get uniformly bullish on a stock and increase price targets and valuation multiples, it is a signal for him to look elsewhere.

His attitude about target prices highlights a couple of important lessons for all investors.

First, the pros aren’t looking to buy and sell entire positions on a monthly or even a quarterly basis. If investors plan to hold a stock for years, then a price target reflecting the next few months isn’t all that relevant.

Second, price targets are just a signal. They are the proverbial tip of the iceberg, and there is a lot going on below the waterline. Price targets tell a story about how Wall Street feels about a stock, but often not much more.

Still, knowing something about target price formation and valuation can make you a better investor. The key is not to take extreme price targets at face value or put too much faith in one number.

The place to start is knowing that the S&P 500 trades for 17 times estimated 2019 earnings, in line with its five-year historical average and 5% higher than its 30-year average historical average. Over the past 30 years, the market traded for about 25 times estimated earnings during the dot-com euphoria and for 11 times earnings in the depths of the financial crisis.

With that knowledge, and armed with a little more detail about price targets and their formation, investors can get back to evaluating business models and company management teams.

That’s a target that can work for all investors.

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