A stock target price is an estimate of a company’s future price based upon earnings forecast and assumed valuation multiples. It’s a calculated guess with a couple of very important caveats.
If it were possible, wouldn’t it be nice if we could know the exact price a company was worth at any point in time? We could buy underpriced companies (value investing) and turn around and sell them once they become overpriced.
Or, if we knew that the company GIZMO would be worth $100 in two years and is only $60 today. We could buy it, put it away for two years, then sell it for $100.
Unfortunately, “shit” happens.
- An oil spill off the gulf.
- A recession.
- An E. Coli outbreak.
- A terrorist attack or BREXIT.
These are things that cannot be forecasted.
But let’s pretend that we live in a perfect world and nothing bad happens. Could we then identify the price of a stock today (value) and/or predict a future target price (growth)?
We could do our own analysis of the company. But this is time consuming, although it certainly does NOT require an MBA from Wharton School of Business to accomplish.
Or, we could follow the highly paid and trained analysts from respected financial companies like J.P Morgan and Merrill Lynch. They should be accurate and reliable, right?
Ratings tell us what a particular analyst has to say about a stock.
“Buy, buy, buy.” Can you hear Jim Cramer’s voice as he shouts this out?
“Buy”, “sell” and “hold” ratings are ubiquitous and effective because they tell you exactly what to do today.
These ratings are from the reasoned and objective analysis of experienced professionals. They take a lot of time to analyze a company, they develop and maintain earnings forecasts. So, why do similarly trained experts, using the same available information reach different conclusions?
A recent look at Yahoo financial shows 47 analysts following Apple.
Of these 47 respected analyst, 17 have a “strong buy”, 22 have a “buy” and 8 have a “hold.”
Are they looking at the same company?
There are four key aspects for determining a target price:
- Earnings per share (EPS) forecast
- Assumptions (errors) underlying the EPS forecast
- The valuation multiples used and…
- Their assumptions (more errors).
Again, let’s look at Apple. The current quarter EPS estimate ranges from $1.23 to $1.47, nearly a 20% range.
Next years (2017) EPS estimates range from $7.46 to $10.1, a 35% range. And these are from experts analyzing a large, established growth company with a steady track record.
What about a company that is large, well followed, but relatively new like Tesla?
Of the 20 analysts with ratings they are all over the board:
4 strong buy; 5 buy, 5 hold, and 6 underperform.
And next year’s earnings estimate ranges from $1.15 to $5.11, a 344% range!
SHOW ME THE DATA
rav and Lehavy, “Using Expectations to Test Asset Pricing Models” in 2003 showed that the market reacts to the publication of target prices. The average buy-and-hold return for the least favorable revisions is -3.96% and the most favorable revisions showed a +3.21% abnormal return.
Asquith, Mikhail, and Au (2005) examined the market response to published targets in “Information Content of Equity Analyst Reports.” They established a model that included target price changes and earnings forecast changes.
- They found that the market reacts more to target price forecast revisions.
- Price forecasts are achieved in only 54.28% of all cases.
- If the target price is achieved it is overshot by 37.27% during the 12 months.
- If the target price is not achieved it is undershot by 15.62%.
Mark Bradshaw and Lawrence Brown tested the accuracy of 12-month stock price targets in their 2005 paper, “Do Sell-Side Analysts Exhibit Differential Target Price Forecasting Ability?” They concluded:
- Stock prices reach targets only 35% of the time.
- The higher the gap between the current and the target price, the less likely it will reach the target.
- Price targets are more likely to be met when market returns are higher than predicted.
- The market does react to stock price targets but, the market understands that hitting the stock price targets is more luck than skill.
In 2006, Cristi Gleason, W. Bruce Johnson, and Haidan Li published, “The Earnings Forecast Accuracy, Valuation Model Use, and Price Target Performance of Sell-Side Equity Analysts.”
- The accuracy of price targets depends on the accuracy of the EPS forecast inputs.
- There is no evidence of sustained ability to accurately forecast price targets.
- Higher volatility stocks are less predictable than low volatility stocks.
Loh and Mian (2006), “Do accurate earnings forecasts facilitate superior investment recommendations?” described a strategy that is long in favorable stocks and short in unfavorable stocks as issued by the most accurate analysts (earnings forecasts). This strategy earned a statistically significant return of 0.737%. The least accurate analysts generated a -0.529% return.
Bonini, Zanetti, Bianchini, and Salvi (2010), “Target Price Accuracy in Equity Research” found that forecasting accuracy is limited with prediction errors up to 46%.
In 2012, CXO Advisory Group, an investor research firm, explored whether there is useful guidance from stock market experts, http://www.cxoadvisory.com/gurus/. They examined 6,582 forecasts from 68 experts from 2005 to 2012. They evaluated calls on the U.S. S&P 500, not individual stocks.
- Consensus accuracy was just under 47%.
- The distribution of forecasting accuracy by the Gurus was a normal bell curve.
- The average guru was also accurate 47% of the time.
- The highest accuracy was 68% and the worst was 22%.
- Jim Cramer’s accuracy was 47%.
- Ben Zacks, Zacks Investment Research and portfolio manager at Zacks Wealth Management Group, had 50% accuracy.
- Abby Cohen, partner and chief U.S. investment strategist at Goldman Sachs score was 35%.
- Robert Prechter, president of Elliott Wave International, publisher of the Elliott Wave Theorist was the worst with a score of 22%.
Factset, a company that provides financial information and analytic software, published “Target & Ratings” on July 1, 2016. This paper explored where the S&P 500 is heading, according to analysts.
- Analysts project a 10% increase for S&P over the next 12 months. On June 30, 2016, the 12-month target price is $2308.65
- Over the prior year (2015), the analysts overestimated the target by 9.7%.
- Over the previous five years (July 2011 to June 2016) they overestimated by 1.6%.
Target price predictions are NOT guarantees of a stocks future worth. Even the best analysts can be wrong half the time. When looking at target price predictions keep in mind:
- Analysts are not concerned with the individual investor. Their focus is on large clients such as Hedge funds and Mutual funds.
- The forecast price target is most dependent on an accurate EPS forecast which can vary greatly between analysts and depends on the company being analyzed.
- The closer in time the estimate is, the more accurate it may be. Trust next quarters estimate or this year’s estimate more than next years.
- The market does move based upon new price target estimates (revisions), however the estimate is rarely reached. Knowing that the market will move is good knowledge, but don’t rely on the estimate itself.
Don’t waste time calculating your own earnings estimate. Use the estimate from the largest and best known financial firms, or the consensus estimate – knowing the whole time that they aren’t accurate and the predicted price is a coin-toss at best.
Predicting economic growth, interest rates, currencies or the stock market is folly. Warren Buffet, in his 1994 Berkshire Hathaway annual report, stated
“We will continue to ignore political and economic forecasts which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%. But surprise-none of these blockbuster events made even the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.”
At KWM we seek temporary abnormalities to profit from. We find this in great, high-quality companies that have an “economic moat” as defined by Warren Buffett. Next, we identify momentum and invest with momentum realizing that it may only last a week, a month or at most 3 months.
KWM also builds value through options allowing us to either profit from the option premium or to purchase a great company at a temporary discount.
Remember, luck does not apply to evidence based trading.
James Krider, MD
Dr. James C Krider is a practicing family physician in Apple Valley, CA. Dr. Krider is a licensed insurance agent in the states of California (0I65488) and Nevada specializing in Medicare Advantage and Life insurance, an important aspect of wealth planning.
You can visit our current lists of momentum stocks here, or view our monthly value stocks here.
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