Zeroing In on Price Targets: How Analysts Set Them -- and Why

The transitive verb to Blodget entered the Wall Street vocabulary on Dec. 16, 1998. That day, young Internet analyst Henry Blodget stunned his older colleagues by initiating coverage of Amazon.com (AMZN) with a strong buy and an eye-popping price target of 400. The effect was sublime: Amazon rocketed from 289 to 480 (presplit) within weeks, and Blodget soon graduated from CIBC Oppenheimer to Merrill Lynch and financial-media stardom.

With the recent hard times in the Nasdaq, few stocks have been getting Blodgeted lately. But the price targets that influential brokers set can still have plenty of impact. The question is, how much stock should you put in them?

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Understanding how to use price targets involves understanding how the numbers get crunched. Analysts employ a multiplicity of valuation methods, but most common is the PEG method, which tethers a company's price/earnings multiple to its rate of earnings growth. Using a 1-to-1 ratio between a stock's P/E multiple and its growth rate, a stock with earnings growth of 25% should have a forward P/E of 25. Whatever price the stock would have to trade at to produce that P/E then becomes the target price: If the analyst expects the company to earn $2 per share, the target price is 50.

That's the tried and true method. But the crop of New Economy stocks that has come onto the market over the past few years has forced analysts to rely on different ways of calculating valuations. An Internet company that doesn't have any profit can't be valued on a P/E basis, simply because there aren't any earnings. So an analyst might employ a discounted cash flow model, something that has traditionally been used for businesses like cable and utilities companies, whose huge upfront infrastructure costs can complicate their near-term earnings growth. In cases like those, analysts will estimate future cash flow and then calculate what that is worth in current dollars.

DCF models can get a bit too complex for the uninitiated, but they provide the kind of mathematical approach that analysts like to use. "It's a quantitative process," says Rob Martin, technology analyst at Friedman Billings Ramsey. "There's not too much qualitative about it, because it's all a function of valuation."

Well, yes and no. Any formula is only as good as its variables, and those used by analysts to set price targets can be quite subjective. They rely on such contestable assumptions as the quality of a given product; how well-positioned a company is to market it; management's ability to execute its sales plan and so on. In discounted cash flow analyses, very minor changes on the input side can produce dramatically different results. "The variation of the discount rate" -- the interest rate used to calculate the present value of future money -- "makes all the difference in the world," says Tom Brown, manager of investment management firm Second Curve Capital. "The debate over these price targets really is in the details."

And as much as the analyst community is loathe to admit it, price targets are indeed influenced by things besides the fundamentals. For one thing, there's the need to maintain delicate relationships with the executives who provide analysts with valuable guidance on earnings. "It's very difficult for analysts on the sell side to have price targets below where the shares are," says Nick Moore, analyst at Jurika and Voyles. "The primary reason is, do you want to talk to the CEO? The stock price is a fairly personal thing to a lot of CEOs."

Target revisions can also reflect changes in market momentum. Last November, within two days, Deutsche Banc Alex. Brown's Brian Modoff issued successive price targets of 250 and 320 on Qualcomm (QCOM). It wasn't fundamentals that prompted the second target, which came without any revisions to earnings estimates. It was Qualcomm's surge past the previous 250 target.

After 15 years as a sell-side banking analyst, Brown knows that price-target changes are often done for less than scientific reasons. "Let's say the investment bankers wanted us to be very positive about a company," he says. "To get investors excited, we'd have to come up with a target at least 15%, and preferably 20%, above its present price. And if you want to have a testosterone surge, you put in a target that's double."

Anecdotes like that illustrate the dangers of using price targets as a rigid guide for investment decisions. Buying at the peak of a "testosterone surge" can be a nightmare situation -- just ask anyone who bought Qualcomm at 200 in the wake of PaineWebber analyst Walt Piecyk's 250 target (1,000, presplit).

There's also the matter of missed opportunity. "What's your price target on Microsoft(MSFT) 10 years ago?" Brown asks. "It's not relevant. Stocks go through periods of being undervalued and overvalued, but in that period, the most important thing was to own Microsoft. There were times when it was above its targets -- would you have sold it?"

So should individual investors pay no attention to target prices? Well, not really. At a minimum, it's important to know that some institutional investors take them very seriously. "I have clients who insist on price targets," Martin says. "I've had institutions actually sell stock based on the fact that they claim that the stock hit the majority of the price targets out there, when in reality, the stock went up twofold or threefold from there."

Ultimately, then, the most important thing to know about price targets is that they spotlight potential trigger points. Selling by institutions could depress stock prices enough to create contrarian opportunities for more nimble retail players who believe in a company's fundamentals. Even if you don't care about price targets, it helps to know that others do.

Target Practice Diverging reactions in Qualcomm and Amazon shares illustrate the perils of basing investment decisions on price targets.

Source: Baseline

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