Beware of Target Prices

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Beware of Target Prices
by Jeffrey P. Ryan, CFA, Senior Equity Researcher, Schwab Equity Ratings®, Schwab Center for Financial Research
September 28, 2006

Reprinted from the Sept. 21, 2006 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

"I don't understand how you can manage a stock portfolio without target prices to buy and sell!" groused one investor on a discussion board recently.

Knowing the best prices to buy and sell a stock would certainly be useful. Unfortunately, accurate knowledge of those prices is only possible in hindsight. "If only I had bought Enron at $18 in August 1997, and sold at $89 in September 2000 ..."

Successful stock investing involves buying undervalued stocks and selling stocks that are overvalued. But academic research shows that target buy and sell prices don't help investors follow that rule. In fact, we believe they can actually hurt investors, which is why we at Schwab refuse to calculate them. Here's why they can be hazardous to your wealth—plus, a better way to determine when to buy and sell.

Target sell prices: unreliable
Let's begin with target sell prices, which represent the analyst's belief about what a stock's price will be at some point in the future. There are many ways to calculate such target prices. A simple "relative multiple" approach involves three steps:

Forecast earnings per share (EPS) or some other fundamental value measure such as cash flow or sales per share.
Forecast a valuation multiple, e.g., a price/earnings (P/E) ratio, adjusted for macro, industry and firm-specific characteristics.
Compute the target price, using the forecasted fundamental value measure and the forecasted valuation multiple.

Sounds logical enough. But academic research suggests it's difficult to accurately forecast either fundamental values or valuation multiples, much less both. The problems that plague analysts' estimates and recommendations (management pressure, excessive optimism, conflicts of interest, etc.) make it difficult to reliably forecast fundamentals. Valuation multiple forecasts are even harder, since unpredictable macroeconomic factors can have major effects on multiples. Finally, the next time you see a target price, look carefully at the supporting analyses—they tend to vary considerably in quality, depending on the source.

In one recent study of target sell prices, professors Mark Bradshaw of Harvard and Lawrence Brown of Georgia State concluded that "analysts do not exhibit persistent differential abilities to forecast target prices ... the market acts as if it understands analyst inability to consistently forecast target prices and discounts more optimistic target prices." The authors' bottom line: Target prices don't seem to be consistently correct—or even correct a majority of the time.

Can an inconsistent and inaccurate approach really help your portfolio's performance? Not likely. What's more, target sell prices tend to provide artificial hype to stocks, fueling investor interest simply because a stock's target price is set at some high level that may not be attainable. Put too much faith in them and you may end up holding on to an overvalued stock too long.

Target sell prices also lack a risk perspective. Statements like "XYZ has 22% potential upside to target, versus ZXY's 35% potential upside" say nothing about the stocks' relative risks. In fact, as Bradshaw and Brown noted, the larger the "potential upside," the greater the probability that the forecast is excessively optimistic. Searching for rewards without considering risk can be hazardous.

Finally, remember our rule for investment success—buy undervalued stocks and sell when they become overvalued. Suppose you purchased a stock at $42, with a target sell price of $56. The stock reaches its target, but the source of the original $56 target price has since raised that target price to $68. Apparently, then, the stock was undervalued at the original target price—a price which, in a sense, represented "stale information."

Target buy prices: pointless
Now consider target buy prices—much less common—which represent the analyst's belief about the price at which an investor should buy a stock. Suppose you're considering buying a stock currently trading at $25. The target buy price set by an analyst is $22. So you wait, and the stock price rises to $30, at which point the analyst raises the buy price to $27. You wait some more, the stock rises to $35, and the analyst raises the buy price to $32 ... (repeat as necessary, ending in frustration). Or consider the same stock, trading at $25 with a buy price of $22, and the market drops by 15%. Is the stock still a buy at $22? Or has the target been lowered? Target buy prices are, in my opinion, pointless.

A better way: Schwab Equity Ratings
We believe Schwab clients have a more straightforward source of guidance available: Schwab Equity Ratings. If a stock is priced at $25 and is A-rated, it's relatively undervalued. And if its price goes to $42 and it's still A-rated, it's still relatively undervalued. When does it become overvalued? When it's D- or F-rated, whether that occurs at $15 or $50. And those ratings are consistently based on the stock's underlying characteristics of fundamentals, valuation, risk and momentum.

Target prices seem like precise guides to decision making, but a closer look shows that "precision" is artificial. In our view, it's better to be approximately right than exactly wrong. We believe that using Schwab Equity Ratings is a much more useful approach for when to buy and when to sell than the artificially precise guidance of target prices.

Important Disclosures:
Description of Schwab Equity Ratings and Components

Schwab Equity Rating Percentile ranking distribution Schwab Equity Ratings distribution 12-month return outlook General buy/hold/sell guidance

A 1-5 Top 5% Strongly outperform Buy

B 6-30 Next 25% Outperform Buy

C 31-70 Next 40% Marketperform Hold

D 71-95 Next 25% Underperform Sell

F 96-100 Bottom 5% Strongly underperform Sell

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinion are subject to change without notice. The Schwab Center for Investment Research® is a division of Charles Schwab & Co., Inc. All charts and research have been compiled from publicly available, proprietary and/or licensed data. Past results are not indicative of future performance. Diversification and asset allocation do not eliminate the risk of investment losses.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

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