What are analysts’ one-year stock price targets based on?
No, analysts don’t spin a big wheel or throw darts at a board to come up with their price targets, although it might seem like it at times. In reality, price targets are based on a valuation methodology that often involves estimating a company’s earnings and then applying a price-to-earnings multiple to that number to determine where the stock should be trading – at least in theory.
Consider utility operator Fortis Inc. (FTS), whose shares closed on Friday at $41.60.
Analyst Robert Kwan of RBC Dominion Securities has a one-year price target of $49 on Fortis, derived by assigning a multiple of 19 to the company’s estimated 2019 earnings per share of $2.59. Why a P/E of 19, as opposed to, say, 9 or 29? Well, 19 is toward the upper end of Fortis’s 10-year P/E range and, according to Mr. Kwan, it’s justified by the company’s healthy growth outlook.
A price target is only as good as the numbers that go into it. If Fortis’s actual earnings miss estimates, or if the market decides to assign a lower P/E to the shares, Fortis’s stock could fall short of the target. In a recent note, Mr. Kwan cites several risks to the price target, including unfavourable regulatory decisions, weak economic conditions and financial or operational issues at recently acquired businesses.
P/Es and earnings estimates aren’t the only numbers analysts use to determine price targets. Other measures include the EV/EBITDA ratio (enterprise value – essentially market capitalization plus debt – divided by earnings before interest, taxes, depreciation and amortization) and discounted cash-flow analysis, which estimates what the company’s future cash flows would theoretically be worth today. In some cases, analysts will use two or three valuation methods and then calculate the average to determine a price target.
For utilities and other companies with relatively predictable earnings, analysts’ price targets are usually clustered fairly closely together. Targets for pipeline and power company TransCanada Corp., for instance, range from a low of $60 to a high of $74, according to Thomson Reuters. The shares closed on Friday at $55.14.
But for more speculative companies whose earnings are harder to predict, price targets can be all over the map. Shares of marijuana producer Canopy Growth Corp. (WEED), which closed on Friday at $36.04, could be heading as high as $51 in the next 12 months, or as low as $22, depending on whose target you believe. Analysts are just as divided on electric-car maker Tesla (TSLA), which closed on Friday at US$276.85. The most bullish analyst sees Tesla soaring to US$470, while the most bearish sees it plunging to $180.
With any stock, you should treat price targets with caution. An unscrupulous brokerage could use a lofty price target to generate interest in a stock. Even with the best of intentions, analysts can badly miss the mark with their calls. A few years ago, some analysts were predicting that Valeant Pharmaceuticals International Inc. (VRX) could hit US$300 a share. It never got there and now languishes at about US$22 after a spectacular collapse.
In general, analysts tend to overestimate where a stock will trade. A 2006 study, by Mark Bradshaw of Harvard Business School and Lawrence Brown of Georgia State University, examined nearly 100,000 price targets from 1997 to 2002 and found that the stock was at or above the target at the end of 12 months just one-quarter of the time. In only half of the cases did the stock hit the target at any point during the year.
“Target price forecasts are overly optimistic on average, and … analysts demonstrate no abilities to persistently forecast target prices,” the authors concluded. “This evidence is consistent with prior findings of low abilities of various experts to forecast interest rates, GDP, recessions and business cycles, and the infrequency with which actively managed funds beat the market index.”
Bottom line: Never base an investment decision on a price target alone, or you may end up being disappointed.