How analysts set target prices

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Most stockmarket investors are enthusiastic readers of the stockmarket reports published in daily newspapers. Many of these contain comments about analysts changing or setting their so-called "target price" for an individual share.

But what exactly are these target prices? And how are they arrived at?

To explain this we need to go back in time. One problem that analysts have always had is that the companies they cover frequently have reacted adversely to 'sell' recommendations. In some cases in earlier years, this was to the point where access to briefings by management was restricted or cut off entirely. In the days when information was less readily available than it is now, this was a big disadvantage.

It's less of a potent threat now. But analysts have traditionally been reluctant to recommend selling a share, certainly in published research and so far as recommendations made to conventional fund managers are concerned. The only instance where sell recommendations are accepted, even actively sought, is by long-short strategy hedge fund managers. These individuals need such ideas to counterbalance the flurry of 'buy' recommendation they get from brokers.

Analysts' freedom of movement is also restricted further because, in the days when corporate finance deals are awarded on a transaction by transaction basis, rather than on the basis of long term broker-client relationships, an analyst never knows whether an adverse view on a stock might compromise some future lucrative corporate finance deal.

In addition, one perennial problem for analysts making recommendations on shares is that they are made in the context of the index level and market environment on the day the research is published. What happens in the case of recommendation to 'buy' a share when the index is 4000 if, a couple of months later, it stands at 5000? The share will most likely have risen in price, but has it outperformed the market? Is it still cheap?

This is the reason why in many instances a simple 'buy', 'sell' or 'hold' recommendation has morphed into something more convoluted like 'market performer', 'good value', 'fairly priced'.

The idea of setting a target price for a share began, so far as I can see, in the US during the dot.com era. It may perhaps be older than that but, again as far as I am aware, it was at this time that British brokers and investment banks began using the term more actively than they had before. The idea, of course, is that a target price is an aspiration rather than a recommendation, and can be dressed up as something arrived at objectively in a mathematically precise, quasi-scientific way, rather than being simply an opinion.

Best guesswork

In reality, it is no more than a guess, backed up by assumptions.

All brokers are different, of course, but for the most part target prices are set by looking at two specific measurements to see if they intersect. Both rely on forecasts, often forecasts for more than one year ahead.

The first benchmark used to set target prices is frequently a "peer group comparison" with the earnings multiples on companies in the same sector. Analysts will frequently argue that a company may merit a higher multiple than its peers by virtue of its superior growth, better management, or some other reason. As well as earnings, other measures - such as enterprise value to EBITDA - might be used.

The other benchmark used is typically discounted cash flow (DCF) analysis. This entails making forecasts of cash -low up to 10 years ahead and making assumptions about appropriate discount rates to arrive at a per share value. Small variation is assumptions can make a big difference to the end result.

The ideal is, of course, to have a situation where the separate valuation methods used produce valuation numbers that are similar. If there is a big disparity, an analyst will have to use judgement to decide whether or not the assumptions being made are faulty.

Peter says

One of the problems with relying on target prices is the subjective judgements that go into setting them. While seemingly scientific and transparent, there is a temptation for assumptions to be adjusted to produce a desired pre-set result. The idea that target prices are somehow objective and statistically accurate may be true in rare cases, but should generally be resisted.

The other problem is that target prices are frequently changed without warning, sometimes by large amounts.

While target prices are interesting in the sense of illustrating the potential that a share might have to appreciate under certain circumstances and assumptions, they are best treated as a guess like any other. At the very least, the reasoning and assumptions behind the number need to be examined very closely indeed before placing any reliance on them.