How useful is a stock’s price target?

February 13th, 2008

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If you have access to any brokerage research, you will often notice that brokerage analysts often have ‘price targets’ for stocks. Usually, these price targets have a one-year time frame. In essence, price targets are just brokerage analysts’ predictions (or more accurately, guesses) of stock prices in one year’s time.

In reality, how useful are price targets?

Bias, vested interests and incentives
A brokerage company makes its money by providing brokerage services (that is obvious isn’t it?). That is, the more you trade, the more they make money from you. Therefore, you should never expect brokerage analysts’ price targets to serve your best interests. This is not to say that they deliberately acts contrary to your interests, but the power of incentives can easily sway the sub-conscious thinking of any human. For this reason, you will notice:

  1. Buy recommendations are more likely than sell recommendations because the former is applicable to everyone while the latter is only applicable to those who already own the stocks. Therefore, the former is more likely to generate more trades, and thus, more profits for the business. In the same way, hold recommendations are relatively rarer.
  2. Have you notice that brokerage analysts’ price target tend to follow the views of the crowd? Notice that crowd opinions tend to change easily with every whims of fancy.

Precision vs accuracy
You may notice that price targets tend to be highly precise (e.g. $3.67). Again, as we mentioned in Confusion between precision & accuracy, just because a number is precise does not necessarily mean it is accurate. Analysts often use complex mathematical models to calculate the ‘intrinsic’ value of a stock. As this book, How to Pick Stocks Like Warren Buffett (commented in our Recommended Books section) says,

By relying on so many variables to predict stock-price performance (sales, market share, interest rates, currency rates, operating costs, shares outstanding, options, earnings per share, and the public’s prevailing mood over stocks), analysts unwittingly expose themselves to the chain link of errors. As their models grow more complicated and detailed, the rate of failure increases.

This is akin to the situation that we described in Myth of diversification as safety?Part 2: nature of risk,

Therefore, risk is something that you cannot simplistically reduce to a precise number obtained from a mathematical model. As we said before in How do you define risk?, risk has to be defined in terms of the ?soundness of the underlying economic and financial state.?

In the same way, the value of a business cannot be easily be reduced into a precise number using a mathematical model.

Real-world vs models
A business exists in the real world where Black Swans and unknown unknowns happen, where entrepreneurs make decisions that changes the status quo. As we said before in See like an entrepreneur… how will Telstra be like in 2010?,

We believe the reason is in the difference between the thinking of analysts and entrepreneurs. Analysts, by definition of their job description, look at businesses through the eyes of the status quo. Yes, they may engage in the forecast of future earnings of a business, but their forecasts are usually made by extrapolating from the status quo or some other derivations from it. Entrepreneurs, on the other hand, look at businesses from the eyes of what can possibly be in the future. As such, what others see as ?impossible? is an opportunity for entrepreneurs to force the camel through the eye of the needle.

In other words, there are far too many dimensions in the complex real world that can never be captured in models. In fact, we would go as far as to say that no matter how complex a model is, it can never match the complexity of the real world. In that case, how should investors look at a stock? The very best investors look at a stock from the vantage point of a business owner. A business has its subtleties, nuances, relationships, personalities, culture, politics, environment and so on. These are impossible to be reduced into a model.

Flexible and elastic
Price target models have one major weak point: by simply tweaking the parameters and assumptions of a model, one can tweak the end result (price target) produced by it. This means that price targets can be flexibly and elastically adjusted to fit according to the bias, incentives and interests of whoever produces the stock research. But in the real world that a business resides in, problems and issues cannot be tweaked and assumed away.

Finally, in conclusion, there is no escaping of the fact that the best investors are the ones who understands business. This is because, ultimately, everything you invest in is ultimately a business or related to a business. Therefore, it pays to cultivate your own sense of business.