What You Need to Know About Price Targets

03/30/2012 11:45 am EST


John Heinzl

Reporter and Columnist, GlobeInvestor.com

Analysts’ predictions of a stock’s future value can be hit and miss, which may not be surprising, but the foundation beneath some estimates can be weaker than for others, writes John Heinzl, reporter and columnist for Globe Investor.

I often see analyst price targets mentioned in the business section. What do these targets mean? Are investors supposed to sell when the stock hits the target?

No. Price targets reflect what the analyst believes a stock will be worth at the end of a certain time period—usually one year or 18 months, depending on the broker.

Price targets are related to, but not the same as, "buy", "sell," and "hold" recommendations. For example, if a stock is trading for $50 and an analyst has a 12-month price target of $100, you can bet he or she will also have a "buy" recommendation on the company.

If the stock hits the target within the 12-month period, however, it doesn’t necessarily mean the investor should sell. That’s because the analyst may well have changed his or her price target in the interim. A good example is Apple (AAPL); analysts have been raising their price targets on the iPhone and iPad maker for years as the company’s earnings and stock price march higher.

Sometimes it may seem like it, but analysts don’t just pull their price targets out of thin air. Typically, they estimate what the company’s earnings and cash flow will be for the next couple of years, and then apply a ratio—such as a price-to-earnings ratio—to those estimates to determine what the future stock price should theoretically be.

Let’s look at a real-life example. Benoit Poirier, an analyst at Desjardins Securities, has a 12-month price target of $85 on shares of Canadian National Railway (Toronto: CNR), which closed Thursday at $79.09.

He arrived at that target, in part, by assigning a price-to-earnings multiple of 17 to CN’s expected per-share earnings over the next 12 months. Why 17? Because that’s the average historical P/E multiple for US railways.

Analysts also commonly use two other valuation methods, namely the EV/EBITDA ratio and discounted cash flow analysis to arrive at their targets. EV/EBITDA is enterprise value (essentially market capitalization plus debt) divided by earnings before interest, taxes, depreciation, and amortization.

Discounted cash flow analysis estimates what the company’s future cash flows would theoretically be worth today. In Poirier’s case, the price target is based on an average of all three methods.

Price targets frequently change, depending on the outlook for a company’s earnings. This week, for example, analyst Paul Lechem of CIBC World Markets raised his price target on Enbridge (ENB), a stock that I own, to $44 from $41, after the company announced plans to boost pipeline capacity to the US Gulf Coast. The new $44 price target isn’t carved in stone, however.

"Based on what we know today, that’s where we believe the stock should fundamentally be a year to 18 months from now, but a year to 18 months from now, life changes," Lechem said in an interview.

Some investors are suspicious of price targets, seeing them as primarily a way for the brokerage industry to generate interest in a stock. Indeed, whether intentionally or not, some price targets have been badly off the mark.

One of the most glaring examples is Research In Motion (RIMM). Two years ago, some analysts had price targets of more than $100 for the BlackBerry maker. But RIMM’s stock instead went into a downward spiral; it closed Thursday at $13.69.

RIMM may be an extreme case, but it’s not isolated.

In a 2006 paper titled "Do Sell-Side Analysts Exhibit Differential Target Price Forecasting Ability?," Mark Bradshaw of Harvard Business School and Lawrence Brown of Georgia State University examined nearly 100,000 12-month price targets issued by analysts from 1997 to 2002.

The study found that the stock met or exceeded the target price at the end of 12 months just 24% of the time, while in 45% of cases the stock met or exceeded the target price at some point during the 12 months.

Analysts do exhibit skill in forecasting earnings, the researchers said, but "target price forecasts are overly optimistic on average, and…analysts demonstrate no abilities to persistently forecast target prices."

To be sure, all sorts of exogenous factors—the economy, interest rates, and the prevailing mood of the market, for example—can play havoc with stock prices. That’s one more reason to treat analyst price targets as the informed estimates that they are, not as the definitive word on where a stock is heading.

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