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Ask TheStreet: Target Practice

Gregg Greenberg

Editor's Note: Ask TheStreet is designed to answer questions about the market, terms, strategies and investment methods. Please email us to ask a question, but keep in mind that we cannot offer specific investment advice.

Can someone please explain the logic behind stock-price targets? When an investment bank announces a price target for a stock, what exactly does it mean? More often than not, it seems that their price targets are too high, leading me to question if we should even give any consideration to them. -- J.N.

Gregg Greenberg: When famed research analyst Henry Blodget set a $400 price target for Amazon.com (AMZN) in December 1998, it was akin to Babe Ruth calling a home run by pointing to the outfield bleachers with his bat. Back then, analysts were the giants of Wall Street, calling the shots and earning huge paychecks for it.

Like in baseball, however, times have changed on Wall Street. Nowadays, the situation regarding price targets is more like a Barry Bonds homer.

Yeah, it's out there and garners attention, but its validity is questionable. That's why investors are best served by looking at analysts' target price as guidance and not as gospel.

Research analysts spend their days trying to find values for the stocks they cover. It's not an easy job because there are so many variables at play. And the targets aren't affected just by company-specific variables, like earnings and sales, but also by external ones, like interest rates and the overall health of the global economy.

With so many factors up in the air, it's absolutely impossible for analysts to calculate the exact price of a stock. The best they can do is offer a target so investors can get a sense of their opinion and conviction of the overall direction of the stock.

Targets are created predominantly through different valuation techniques, such as sum-of-the-parts (valuing the company by adding together what its segments would be worth if they were broken up), price-to-earnings comparisons or discounted cash flow (a complicated analysis of cash projections). These aren't exact sciences -- and very often the results will conflict even on the same stock -- but each method is useful in its own way when valuing a company.

Moreover, many of the truly sketchy valuation methods of the Internet bubble -- remember "price to page views?" -- have been abandoned. So, however imprecise the valuation methods may be, at least they are tried and true.

Once the appropriate price of the stock is determined, analysts can offer a target as to where it will be in the future if nothing changed. Price targets are usually set for 12 months in research reports, but some brokerage houses will go longer, to 18 months. The length of time should be spelled out in the report, along with clear definitions for the ratings like buy, sell or hold (and that's a whole other can of worms!).

It's worth mentioning that the analyst community has certainly cleaned up its act since the bubble days. In April 2003, the SEC reached a $1.4 billion global settlement with 10 of the top U.S. investment firms designed to straighten out the faulty research problem on Wall Street.

Baseball and Barry Bonds, meanwhile, are still engaging in business as usual.

What do you think of services where people with a limited budget invest based on dollar amount and buy stocks over time? Is this the best way for long-term investors? Thanks, A.J.

The process you're referring to is called dollar cost averaging, which can be an effective way to leverage your investments. By legging into a stock on a set schedule, instead of jumping in all at once, it smoothes out the investing process and saves investors from kicking themselves if things don't go as planned.

Dollar cost averaging is the process of investing regularly through automatic investments in order to accumulate your investments over time, regardless of share price. Using this technique means investors will buy more shares when prices are low and fewer shares are bought when prices are high. Some services, like Sharebuilder.com, allow you to buy partial shares of stocks.

Saving up your money and jumping into a stock all at once could yield you a big pay day if you time it right. But, as they say, timing is everything. And if the timing is off, it will definitely be hard for a person with a limited budget to recover from a big blow. So, a slow and steady outlook may be best for cautious investors.