With target prices you can easily overpay
Through my discount broker I have access to two quite different kinds of analysts’ reports. The first are published by Morningstar which provide a fair value estimate based on a discounted cash flow (DCF) calculation. The second are what is known as ‘sell side’ analysts’ reports that offer target prices based typically on ratios.
For readers not familiar with DCF analysis take a look at my introduction to the subject: The dangers and benefits of using Discounted Cash Flow analysis reports
Target prices and estimates of fair value are two quite different animals. It is easy to confuse them.
A real life example
It has been my experience over the years that the sell side analysts’ target prices are almost always substantially higher the DCF fair value estimates. I record both on computer price charts of the companies I own. Let’s look at the chart of Applied Materials, a stock I bought last spring.
You will see on the chart below a little icon with ‘RBC target USD 75.00’ below it. That was my discount broker’s sell side analyst’s target price in April 2020. In November 2020 the analyst raised their target to $82.00, and again in December to $95.00. The light blue line connects these targets.
Let’s compare that with the Morningstar fair value estimate. Look at the green lines. It was at $65.00 in May when I bought a 2/3 position at $54.00. A 2/3 position is my short hand way of saying it was approximately a 5% portfolio weighting. I made this purchase based on the work I had done to understand AMAT’s business, its franchise, its management calibre, its sustainable free cash flow yield and the fact that I could buy with a significant margin of safety between the purchase price and fair value as estimated by Morningstar. I bought a further 1/3 position in July, again with a margin of safety. I added a bit more in September opportunistically with some cash I had available. In November, Morningstar raised its fair value estimate to $74.00.
I also looked carefully at the RBC sell side analyst’s reports on AMAT and made note of the target price. It also contained other useful information.
Target prices give no indication of a reasonable price
It is said that the stock market is forward looking. Target prices are typically based on estimates of next year’s earnings or some such. So, does that confirm the market is forward looking? Well, yes and no. As for no, the earnings estimate is for next year. But, so is the target price. That is, the target doesn’t say what a reasonable price would be today. It says what the analyst reckons the stock should trade up to in the next 12 months. As for yes, the market looks forward to the prospects for a company, but it discounts those prospects back to the present.
Back to my real life example. In May, if I had only had the sell side analyst’s target price available, I might have been prepared to pay $70.00 for the stock. I might have thought that with a 12 month target of $75.00 I could expect to do well. The problem would have been that I could easily have been paying more than the stock was really worth. With target prices it’s easy to get this wrong.
In reality, no analyst is capable of predicting the price a stock will reach in the next twelve months. Of course they will respond that it is simply a target; they’ll say they aren’t making a prediction.
Discounted cash flow calculations also look forward. What they do is discount future cash flows to the present. So what they are estimating is the present intrinsic value of the company. So let me come back to the main point of this post. The sell side analyst’s target prices do not estimate fair value. DCF estimate do just that. Investors should not confuse the two.
Understanding DCF is really important for investors. The tags index on the Motherlode home page contains a listing ‘Discounted Cash Flow’. That will take readers to all posts dealing with DCF.
As for sell side analysts’ reports
I have written before about sell side analysts’ reports explaining what the sell side is. See my post How to get the most out of analysts’ reports . I have also written about the game that is played between companies and sell side analysts. Analysts’ reports and the estimate revision game I find the reports very useful. It’s just that you have to keep in mind what price targets mean and not be beguiled by the targets.
An optimistic bunch
Let me make a general observation. Sell side analysts are an optimistic bunch. In looking at the precipitating factors that led to the dot com stock bubble, Shiller considers the contribution by analysts’ optimistic forecasts. He reports that: “According to a study by Steven Sharpe of the Federal Reserve Board, analysts’ expectations of growth in the S&P 500 earnings per share exceeded actual growth in nineteen of the twenty-one years between 1979 and 1999. The average difference between the projected and actual growth rate of earnings was 9 percentage points. The analysts breezed through both the steep recession of 1980-81 and the recession of 1990-91, making forecasts of earnings growth in the 10% range.” (Shiller, Irrational Exuberance, 2005 Second Edition) p45. Based on what I have seen, this is not going to change. Their targets likewise tend to be optimistic.
What to do
My approach, when thinking about an investment, is to make sure I have a good estimate of the intrinsic value of the business. Warren Buffett has written: “[Intrinsic value is] an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: it is the discounted value of the cash that can be taken out of a business during its remaining life.” (Buffett, Cunningham, 1998) p187. We note the words ‘can be taken out of a business’. This in effect refers to Buffett’s concept of Owner Earnings discussed in my post: How to identify great companies to invest in – Part l
An estimate of intrinsic value or fair value (I use the terms interchangeably) using DCF is only that, an ‘estimate’. I have a pretty hard and fast rule that I will only buy shares in great companies, and then only at a very attractive price, giving me a bit of room for error. This is what I have learned from Warren Buffett and some of the other great investors.
To read more deeply on putting together a solid portfolio check out the Motherlode Part 7: Building and managing a portfolio
And on searching for great companies take a look at Chapter 40. Finding and studying companies to invest in
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