Can we take broker price targets seriously?

‘Consensus price targets’ offer a useful if imperfect guide to where stock prices might be heading

What’s the ordinary investor to do with so much conflicting inputs? Picture: AAP

Sharemarket investors — especially those who are new to the area — are often puzzled by so-called price targets: How do they get calculated and can we take them seriously?

Let’s assume I like a certain company, and I would like to buy its shares to add to my investment portfolio.

I might have an idea about what this company does and how it’s positioned in a generally attractive-looking industry.

There is a reasonable track record to study and forecasts are available, too. I might even look at a price chart to see how the share price has performed and how volatile it is. But how much do I think the shares are worth?

It’s an intriguing question, one that can potentially elicit endless discussions about value investor Ben Graham’s base principles and how much influence low inflation and bond yields near historical lows exert on a company’s valuation in modern times.

There is also the added observation that an extremely low valuation is seldom an indication of a low-risk, sustainable longer-term investment, while an above-average price-earnings (PE) ratio is not necessarily a harbinger of a share price crash that hasn’t yet happened.

In reality, many of the stocks trading on higher PE ratios have proven a much better investment than peers on low PEs, and this has been going on for many years now.

Most stockbroking analysts are kind enough to not only calculate a valuation based on their modelling assumptions and forecasts but, in most cases, they provide a “price target”, too — an estimation of where the share price should be in 6-12 months, all else remaining equal.

Those four words at the end of the previous sentence give away the first and foremost mistake many investors make when focusing on stockbrokers’ price targets. Theirs is not a static process, such as determining the distance between Brisbane and Melbourne.

In the sharemarket, as well as in the real world, circumstances and context seldom remain the same for very long.

This clashes with our human desire to receive guidance that is set in stone, irrespective of what happens. It’s the same error investors make when basing decisions on PE ratios.

Years ago, it was pointed out to me that high PE stocks such as REA Group and Seek usually saw their shares weaken around May-June each year.

That’s when PE ratios go beyond historical averages. That is if we continue to focus on the financial year that is about to end and which will trigger the annual reporting season in August.

The crucial error investors made when noting these numbers — and perhaps selling out on that basis — is that professional investors, by now, are already looking forward to the financial year 2021-22.

Sure, we don’t know yet what the exact numbers in August might look like, but if these growth companies continue to grow year after year, then this year’s PE ratio has to look high by May-June.

It’s either that or something’s wrong with how fast these companies are growing.

In other words, financial indicators — whether they be targets or forecasts or a multiple derived from forecasts — should never be treated as an inflexible, stand-alone, set-in-stone, never-to-change indicator.

Always keep in mind things can, and will, change. This, in particular, applies to sectors and stocks that are affected by many moving inputs, such as commodity producers. Another complication is that when multiple experts look at the same company, they often end up drawing different conclusions.

Just now, UBS doesn’t like Afterpay. The broker currently has a price target of $14. At Ord Minnett, the price target was recently raised to $64.70.

No prize for guessing why UBS has a “sell” rating on the stock and Ord Minnett has a “buy”. Most analysts covering Afterpay have a price target closer to Ord Minnett’s, but most are below today’s share price, which is hovering near $70.

So, what’s the ordinary investor to do with so much conflicting inputs? Enter consensus price targets. Years ago, I discovered consensus price targets — essentially the average of targets published by brokers covering the same company — can be used as a handy tool for assessing entry and exit decisions.

As a plain vanilla concept, my interest is usually sparked when a share price weakens more than 10 per cent below its consensus target.

Every time, I try to establish what is the cause of this gap. There is a big difference between market momentum switching out of, say, Coles and Woolworths as a result of portfolio rotation by institutions into banks and commodity stocks and, say, satellite tech company Speedcast issuing yet another profit warning, which forces management to renegotiate the company’s survival with its lenders.

Also, we have to be aware of time delays: In the case of Afterpay, the share price is not sticking around to see what the next upgraded target might be.

Broker forecasts and valuations/price targets can be an extra tool in support of portfolio construction and investment strategies, but they are not infallible, let alone the be-all and end-all for fundamentally oriented investors.

It’s the work of humans, after all, and companies are organic creatures, not simply a mathematical model in an excel spread sheet.

Rudi Filapek-Vandyck is the editor of sharemarket research service www.fnarena.com