Several readers and clients have recently asked questions about target prices for stocks. I have an approach that has proven very effective. Let me start with a review of some abuses and some best practices.
Target Price Abuses
It is easy to name a target price. It is specific and seems compelling to the average investor. An impressive target often confuses what can happen with what is likely. Here are some problems:
- The method for determining the target price may be weak or even unstated.
- The target emphasizes reward while ignoring risk. Tom Brakke of the research puzzle recently wrote a nice piece on this specific topic. (HT Abnormal Returns). It is an excellent article from someone with first-hand experience in the stock research industry.
- The target is often inconsistent with the rating on the stock. Sometimes an analyst has a "Buy" rating, but the stock target is only a couple of points higher. Who would buy for such a small gain?
- The target is moved in an illogical fashion. Suppose the analyst has a target of 31 for a stock. The stock price works higher and finally reaches 31. Does the analyst change the rating to "Sell"? Often not. The most common action is to raise the target from 31 to (say) 37. The timing calls into question the logic and procedure for changing the target price.
- And the biggest abuse of all: Giving a target with no time frame!
Many of the big sell side firms have improved their approach in the wake of the Global Research Analyst Settlement. Firms are more likely to have "hold" or "sell" ratings than before. The report will usually provide data on the percentage of covered stocks in each category. The reports provide a history of past calls along with a stock chart. Professional analysts will always describe assumptions and methodology.
While reports do not include Brakke's "error price," a price that might result if things go wrong, they do highlight crucial assumptions. I find it very interesting to read negative reports. An analyst with a "hold" rating should highlight both upside and downside risks to his rating. Many of them do.
Analyst reports can be very helpful. There is a lot of information about the business model, recent trends, and risk factors. Reading several reports can help in identifying the consensus, especially what the analyst community is worried about. Knowing these concerns can help you anticipate upgrades and downgrades.
I use the raw data to set my own target prices, and I review the targets frequently. I select stocks with a target that is at least 25% higher and with attention to near-term catalysts and risks. I have found that this is a good level for a goal, understanding that it will be achieved only some of the time. Trying for home runs is tempting, but not as effective.
I almost never own a stock at the time it hits a target. This may seem strange, but consider two cases:
- If the stock makes a big move, but the fundamentals have not changed, it no longer has the potential for an additional 25% gain over the next twelve months. I sell and move on to something that meets my criteria. I sell these stocks before the target is reached.
- If the stock makes a big move and the fundamentals keep pace, the target is moving as rapidly as the stock price. This enables me to hold stocks like Apple.
Target prices can be very helpful if created and implemented in a professional manner. Analyst reports can be useful in the process.
Most people follow only the upgrades and downgrades from analysts. This is actually the least useful part of the report.
It is more difficult, but more profitable, to read carefully and critically. Then draw your own conclusions.