One of the most important predictors of short-term stock prices is the backing of market analysts in the form of buy, sell, and hold ratings. Many analysts include a price target in their reports on particular stocks. These target prices are merely an analyst’s best guess as to the future price that a stock will reach. Your online brokerage account will usually link to several such reports. It is important to realize that different analysts determine price targets in different ways. Some are purely quantitative and use regression analysis and other more advanced empirical techniques to predict future prices.
An important consideration when considering price targets is the timeframe that the analyst is using. Most analysts are not catering to the day trader; they are usually looking at least a year into the future. Most analysts will use some form of value approach where the earnings and growth of the underlying company are the critical factors. This means that sector fluctuations, overall market conditions, and market sentiment are not factored into the price model. If a particular stock rises to the analyst’s target, it will usually have many ups and downs before it gets there.
Many investment experts agree that a buy and hold strategy is not a smart investment strategy. Even the greatest companies wane over time. You have to keep an eye on the fundamentals of the stocks you own. Price targets provide one method of helping you determine when a company may have reached its zenith and your portfolio would be better served by taking profit and reinvesting in a stock that still has “room to run.” Note that price targets are often updated by the analysts, and analysts may not update a price target as quickly as they perhaps should. When a stock reaches its current price target, then it should be evaluated as a possible sell.
Value investors will seek to identify companies that are selling at a price that is too low given the fundamentals of the underlying company. Analysts trying to establish price targets must make predictions based on past performance and future potential. Some of the most commonly cited factors that influence a stock’s valuation include its expected growth rate, dividend yield, and financial health. The idea of “earnings visibility” often comes into play. Earnings visibility refers to the likelihood that projections about a company’s numbers are correct. Factors that make the analyst’s crystal ball cloudy, such as regulatory uncertainty, hamper earning visibility. Older companies that have weathered economic downturns are often regarded as safer bets based on this idea of visibility.
Many analysts also include whether or not a company pays a dividend when evaluating the market value of a stock. As you would expect, when all else is equal a company that pays a dividend should trade at a premium to a company that pays no dividend. Dividends provide investors with tangible growth. Some companies have such a long history of paying stable dividends that they are considered to be the equity market equivalent to bonds. Proctor and Gamble is the quintessential example of such a stalwart company.
A company’s financial profile must be considered when valuing a stock. Earnings and earnings growth only tell part of the story. The best of breed companies will have a high return on equity and a high return on invested capital. They will also have good “margins,” which are the proportion of income that’s left over after all of the bills are paid. The adage that “you have to spend money to make money” is true. Great companies have mastered the art of turning cash into even more cash. Some companies have to spend huge sums to generate cash, and the market punishes companies that have a track record of doing this.
This brief overview of how price targets are set demonstrates that setting price targets is as much art as science. The simple truth is that even the best analysts get it wrong sometimes. This is an important reason that you must be diligent and do your homework. You have to know the fundamentals of the companies that underlie your stock picks, and you must project those fundamentals into the future based on a comprehensive knowledge of what the company is doing. Qualitative information about a company is often critically important, and cannot be boiled down into a single number that plugs into a formula.