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Sound Advice: September 20, 2023

Target Prices? Really?

For some investors, the temptation to build portfolios by selecting stocks with the highest target prices, compared to current prices, is up there with believing in the tooth fairy. Yet Investopedia, one of the more competent websites, states the following:

“When it comes to evaluating stocks, target prices can be even more useful than the ratings of equity analysts. Strictly defined, a target price is an estimate of a stock's future price, based on earnings forecasts and assumed valuation multiples.”

That may be accurate, though neither should be taken seriously.  Let’s consider the merit of each.

Current prices for stocks are the products of the following equation: earnings per share (i.e., company net income divided by the number of common shares outstanding) times the price-earnings multiple, which is a numeric valuation of the earnings per share (EPS).  If EPS are $2.00 and the stock sells for 40, the price-earnings multiple is 20.

Target prices are forward-looking extrapolations.  In other words, projected future EPS times an assumed price-earnings multiple.  If the EPS for Company X may grow to $3.00 in five years and the price-earnings multiple remains at 20, one might conclude that the price will rise to 60.

That’s interesting, but deeply flawed since it’s largely a function of the annual rate of earnings growth.  If the rate slows, the price-earnings multiple may narrow.  If it accelerates, the multiple may expand.  Either way, it’s essential to be aware that stocks (and the overall stock market) rarely sell at what might be considered normal valuations.  So target prices are nothing more than crap shoots.

If target prices are essentially meaningless, buy, hold or sell recommendations are total nonsense.  It’s well known that the majority of recommendations are buys pushed by Wall Street houses looking to move large blocks of stock or to satisfy the gullibility of retail investors. Despite this preposterous proposition, there have never been any studies demonstrating that these recommendations are of any value.

Indeed, during my extended tenure at a prestigious investment advisory company, which published stock ratings based solely on quantitative information, a short-term deviation in the ratings method that included the subjective view of the company’s analysts was quickly scotched after it became obvious that those views hurt, not helped, the ratings.

Although target prices and ratings may appear to be of merit, they’re running neck and neck with Casper the Friendly Ghost. 

N. Russell Wayne, CFP

Any questions?  Please contact me at nrwayne@soundasset.com

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