Tuesday, February 28, 2012

Target Prices of Equity Shares – Concept and Utility


Target Price

A target price for a stock is a figure published by a securities industry person, usually an analyst. The idea is that the target price is a prediction, a guess about where the stock is headed. Target prices usually are associated with a date by which the stock is expected to hit the target (Invest FAQ). The normal practice is specifying 12 months.


Target price is the projected price level as stated by an investment analyst or advisor (Investopedia).
A stock trading at $60 might have a one year price target of $90.


Target price model is a fundamental analysis technique.

Fundamental Analysis is based on operating and financial performance of companies.
Fundamental analysis could be value based, target price based or it could have qualitative judgement.  The investment in general can be categorized as quantitative or qualitative judgment oriented.

Similarly, the analysis can be on the basis of past performance or projected performance. Past performance based analysis is easier to understand comprehend.  Certain analytical methods and approaches deal with judgment on positive or negative effect on future performance of news event.

Why Target Prices Are Better for Investors than a Rating?


Risk Wayman supports target price estimates by analysts because they provide additional information that an investor can use to determine if a stock is right for him or her, target prices are better than ratings.



Wayman advises analysts to include a discussion of the historic earnings and price trends and an analysis of these trends through a comparison to a relevant peer group and make a good case for a target price.

Exceptional situation need more in depth argument. If a stock has consistently traded below its peer group average (has been a “discount”) and the forecast expects the multiples to be larger than the peers (to be a “premium”), the analyst has to explain the reasons why the market is expected suddenly to “discover” the stock.

There will be occasions when valuations “pop” (such as when a company gets an FDA approval to market a drug), they are high risk/reward situations and only investors with that type of risk tolerance should accept those assumptions and invest in this type of situation.


Wayman asserts that investors will make better decisions if they focus on target prices, which convey more information for evaluating the potential risk/reward profile of a stock.

Some of the Methods Used by Analysts to Set Target Prices


Genzyme General
Biotechnology
United States

(UBS Report)

Our one-year price target is $32, 23 times our 2003 EPS estimate of $1.40

Daishin Securities
Securities Brokers
Korea

(UBS Report)

The target price is the average of implied fair value calculated at a 5% discount to target sector multiple.
The multiples are estimated for Trailing P/BV, 12 month Prospective P/BPCS, 12M Prosp P/CIPS, 12M Prosp. P/NORPS, FY03 P/E, and FY03 P/PpoP.

People’s Food
Food Products
Singapore

(UBS Report)

Target Price is our DCF estimate for the stock.


Aeroflot
Transport
Russia

(UBS Report)

For valuing airlines, we prefer the EV/OpFCF multiple over the more traditional P/E and EV/EBITDA ratios, as it accounts for the various balance sheet structures and depreciation methods used by different companies.
However, we believe EV/OpFCF shows only part of the picture.
We believe a more reliable valuation metric is implied franchise value of an airline, measured by comparing its enterprise value with the substitution cost of its fleet.
Hence EV/FSC is to be used.
We expect that by 2002E Aeroflot will trade at an average emerging market EV/FSC of 0.75.
Applying this to the 2002E fleet substitution cost of $2,615 m and 2002E net debt of $778 e arrive at an implied forward market capitalization of $845 m.



Sarna Chemicals,
Commodity
Europe

(UBS Report)

At our target price, Sarna would trade on 5.2x EV/EBITDA.
This represents 15% discount to the European auto parts sector.
Our valuation is supported by our DCF calculation, which derives a price of CHF2, 523 per share.
We have applied a 23% discount to get our target price of 1,950 owing to (1) lack of liquidity; and (2) the relatively low capitalization of the stock.



30th May 2000
Computer & Tech
Technology Software,
Hong Kong

(UBS Report)

We base our 12 month price target for C&T on 20x 2002E China earnings for China Business and
50x 2002E e-commerce enabling (or GeBE) earnings.
Added to this is our valuation of the ASP division (or GeBS), which we value on 50x our 2002E revenue projections of HK$16m. This it is a sum of parts valuation.



July 25, 2002
CNH Global N.V. (CNH)
Machinery
USA, July 25, 2002

(UBS Report)

Our 12 month target price assumes that CNH trades to roughly 10 times potential 2004 earnings of roughly $0.70 per share.

Premium over market multiple

December 4, 2002
Network Appliance (NTAP)
PC Hardware, Application software, Enterprise Hardware
United States,

(UBS Report)

We believe a normalized P/E for the market is somewhere in the low 20X range.
If we apply a 100% multiple premium (which is at the low end of NetApp’s historical range) to our estimate of NetApp’s normalized earnings of $0.40, we arrive at our price target of $18/share.

Reduction in DCF value

14 Mar 2002
The Gribbles Group (GGL.AX)
Healthcare Providers
Australia

(UBS Report)

As a result of the reduced earnings forecast, our DCF has declined to $1.00 (from $1.17), Price target $1.00 (from $1.17)

Discount to sector multiple

17 July 2002
Tamedia
Publishing
Switzerland

(UBS Report)

Our new price target of CHF 100 would value Tamedia at 6.5x 2003E EV/EBITDA, implying a discount of c20% to the European media sector.

Price/Book value multiple

10th January 2003
ESEC
Semiconductors
Switzerland

(UBS Report)

Our price target of CHF72 implies a price/book of 1.1x.
The current price at 1.6x 2002E remains well above the historical average (1998-2001) of 1.2x

Premium to Sector Multiple – International Market

September 27, 2002
Nokia
Wireless Equipment
United States

(UBS Report)

Our price target of EUR 20 (US$20) is based on a 2003P/E of 23x, compared to European Tech at 17x.
We believe the premium is justified in view of Nokia’s superior margin, cash generation and growth outlook.

 
Thus we see that a number of different methods are being used by analysts to set target prices for equity shares of various companies

Criticism of Target Prices in a New York Times Article

 
Gretchen Morgenson wrote a critical article on target prices in New York Times.
 
The story of target price on Palm Inc. is the basis for the criticism. On Dec. 5, 2000, Andrew J. Neff, a computer analyst at Bear, Stearns, issued a report on Palm Inc., with a 12-month price target of $80 on the shares, reflecting his belief that they would trade at 19 times his 2001 sales estimate for the company.

Palm’s shares had climbed to $56.625 n a week, and then they began to sink, until, on Jan. 3, 2001 they had reached $27.88. That day, Mr. Neff cut his target to a range of $37 to $48. Two months later, with Palm in the mid-teens, Mr. Neff lowered his target again. Finally, on May 17, the shares stood at $7.05 when he slashed his target to around $5. It closed on Friday at $5.36.

Morgenson said that this was an example of the assignment of target prices that were based more on fantasy than reality.

Morgenson quoted Stefan D. Abrams, chief investment officer for asset allocation at the Trust Company of the West in New York who said that many of the target prices could not be defended by any rational means and these were nothing more than sales hype.
Robert A. Olstein, manager of the Olstein Financial Alert fund was quoted as having said that analysts have become soothsayers, because they're trying to predict where the crowd frenzy is going to take a stock.

The quote attributed to Mr. Mitch Zacks, vice president of Zacks Investment Research in Chicago is ''The price target is the piece of data produced by Wall Street that is least tied to reality.''

Scientific Studies

 

Asquith et al 2005

 
Asquith et al examined the reports of analysts who were given the coveted recognition as members of American analyst team over the period 1997-99.  73% of reports of all American analyst team members contained target prices.
 
They reported the following findings.
 
99% contained EPS forecast for the current year. 95% contained EPS forecast for the next year. Only 23% contained EPS forecasts for one more year.
 
Price target are most often associated with 12 month horizon. They are 33% more than the current market price on the day the report is issued. Approximately 54% of the targets achieved within the year. For the remaining 84% of the target price change is achieved.
 
Regarding analytical models used analysts Demirakos, 2004 found that 89% use P/E multiples. Asquith (2005) reported that 99% used earnings multiples (Earnings, EBITDA) and only 13% used DCF. DCF was more used for downgrades.
   

Gleason 2006

   
Gleason examined target prices of equity shares over the period 1997 to 2003. A total of 223,147 price targets were available from 191 brokerages. He imposed some constraints regarding number of analysts giving target prices etc. and got 34,417 targets for investigation. Target prices provide by 3551 analysts on 2352 companies were analyzed by him in his study.
 
An interesting finding from Gleason et al. is that if the stock was sold at the highest price it reached in 12 months  subsequent to the publication of target price, investors could have made more than 40% return  in recommendation fall in each of the  five quintiles (most accurate to least accurate).
 
Quintile                         Mean Return (% per annum)
 
1. Most accurate          46.73
2.                                 45.59
3.                                 44.32
4.                                 43.59
5. Least accurate          42.49
 
The scientific studies show that target price has useful information content for traders and investors.
   

Theoretical P/E ratio

 
The theoretical P/E ratio could be determined for mature companies whose growth rate is equal to or less than the growth rate of economy. P/E ratios of for growth companies need to be determined on the basis of these growth rates at their maturity time and an additional component for their super normal growth in the interim period.
 
P/E  = Payout ratio/(required rate of return – expected growth rate)
 
The above formula is applicable at market, industry and company levels.
   

References

   
Asquith P., M. Mikhail and A. Au, “Information Content of Equity Analyst Reports”,
Journal of Financial Economics, 75:245-282, 2005
Demirakos, E., N. Strong and M. Walker, What Valuation Models Do Analysts Use?” Accounting Horizons, 18:221-240, 2004

Gleason, Cristi A., Johnson, W. Bruce Bruce and Li, Haidan, The Earnings Forecast Accuracy, Valuation Model Use, and Price Target Performance of Sell-Side Equity Analysts (July 2007).


Gretchen Morgenson, “Price Targets Are Hazardous to Investors' Wealth”, New York Times, August 5, 2001 http://query.nytimes.com/gst/fullpage.html?res=9F05E1D8123CF936A3575BC0A9679C8B63&sec=&spon=&pagewanted=all




 
Why Target Prices Are Better for Investors than a Rating?

Rick Wayman, “Why Target Prices Are Better for Investors than a Rating?”
http://www.investopedia.com/printable.asp?a=/articles/analyst/03/022603.asp
     

Related Articles

 
Fundamental Analysis – Graham–Rao Method
     
Security Analysis Article Directory
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 Originally Published on Knol

Knol number 147

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