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One investment question we often get at 5i Research revolves around how an investor should interpret target prices. For those who may not be familiar with the concept, a target price is essentially an attempt to forecast the profitability of a company and bring it back to present-day values in order to reflect the whole value of a company in a single number. A target price can also be derived by applying a multiplier (from historical multiples or from multiples of a peer group) to some sort of fundamental metric, such as forward cash flow or earnings to get a single value for the company. Target prices typically have a 12-month time frame, all else being equal.
While analysts are quite good at forecasting the actual level of revenue and earnings at a company, they have a harder time predicting the sentimental and psychological factors, as well as the return that the "market" demands in any given environment, all of which have an impact on share prices.
Investors also demand different returns from their investments in different environments. As an example, in today's low-interest-rate world, an investor may be willing to accept a bit more risk and lower returns from equity investments than usual, simply because there are no other assets offering reasonable returns out there. This would be seen through higher trading multiples of stocks and in turn a lower implied rate of return in the future. These types of factors are very hard to predict and are a big reason target prices should be approached with caution.
We took a look at the structure of target prices for 618 companies traded on the Toronto Stock Exchange (TSX) and found some interesting data points:
- Sixty-one per cent were rated a “buy” and 67 per cent were rated a “buy” or “strong buy.”
- Thirty-one per cent of recommendations were rated a “hold.”
- Only 2 per cent of recommendations were a “sell” or “strong sell.”
- The consensus price target on average was 42.1 per cent above the prevailing share prices.
- The median target over prevailing share prices was 15 per cent.
These statistics are harmless at face value but a clear bias toward positive recommendations can be seen. Indicating that only 2 per cent of the stocks out there are worth selling probably makes winning at investing seem a little easier than it is in reality. Certainly, with nearly 70 per cent of companies on the TSX being "buyable," it would appear that the odds of investors making money any given year are pretty good, but performance statistics for investors across the board would indicate that the rate of success is much lower than 70 per cent.
While the positive bias in recommendations is evident, we would be hard-pressed to consider it as dangerous. Where they do become dangerous is through the unrealistic inferred returns that many targets provide.
The average target price being 42.1 per cent above prevailing prices is a very big number and can be quite misleading to investors. In a world where we continue to hear that investors should expect a 5-per-cent to 7-per-cent annual return, on average, it is difficult to reconcile this dissonance. We do think that this leads to unrealistic expectations for many investors. When investors come to expect double-digit returns from their investments, it can lead to them taking unnecessary risks.
One reason this variance may be occurring is similar to the squeaky wheel getting the grease. Instead of viewing a price target in a literal manner, there may be more value in considering the variance from current prices as a signal.
Another reason this positive bias exists is owing to conflicts of interest that are hard to escape. If you are an institution that wants to be involved in a financing of a company, it is very tough to issue (or have issued) a report on that same company that is negative. The pressure to sugar coat bad businesses or management teams is real and is one big reason there are only 2 per cent of recommendations that signal "sell."
Here are a few things investors should keep in mind when approaching target prices:
1) Treat them as one tool in your toolbox. While helpful in gaining a high-level summary of a stock, do not rely solely on these targets.
2) Do not blindly sell when a stock reaches a target price. If anything, view this point as a "re-evaluation signal." Maybe nothing has changed or the prospects look even better than they did when the target was last issued.
3) Consider your investment type. Nowhere does a recommendation indicate whether a stock is appropriate for a retiree living on a pension or a thirtysomething gainfully employed. Make sure the stock makes sense for you.
4) Holds and sells: We would give extra weight to "sell" recommendations whether it is a consensus or a single analyst who goes against the consensus. These individuals are putting their neck on the line and understanding why can be helpful. "Hold" recommendations could be viewed as a near equivalent to a "sell" for all intents and purposes
5) Understand the conflicts. Conflicts exist and are often hard to avoid. Knowing this can go a long way in understanding how to approach a price target.
5i Research offers conflict-free investment research for DIY investors. Members of 5i Research can gain access to the target-price data mentioned in this article. You can also purchase individual reports in the Globe Data Store.