Investors probably have, at some point in their investing journeys, read through a sell-side brokerage report and looked through its contents for investment ideas or inspiration on a particular company or sector.
Previously, I had written about why most brokerage reports recommend a “Buy”. My next topic is on why such reports need to consistently feature a “target price” or “fair value” – does this seem to imply something about the potential growth of the company, or is it just an arbitrary number which the analyst concluded from his detailed financial models? Let’s explore this in detail.
Concept Of A “Target Price”
By coming up with a target price, the inherent assumption is that the business’ cash flow can be i) estimated reliably; and ii) its timing can be ascertained with certainty. Both assumptions are tough at best and almost impossible to determine at worst. These are the limitations of financial models, and back when I was working as an analyst, it would have been more prudent to come up with a range of values based on different scenarios, rather than a specific number.
Investors should be aware of these limitations when perusing through brokerage reports. It is also easy to amend the assumptions for the financial model to come up with different values for a target price – a classic case I see where most of the time, the target price is adjusted only after the share price has moved.
Short Time Horizon
The majority of research reports also peg a one-year time horizon for their price target, which demonstrates the short-term thinking inherent within the industry. In my many years of reading through brokerage reports, I have yet to see one which had a five-year fair value for a company.
The continuous focus on a 12-month time horizon is myopic as businesses need time to execute their plans and strategies to grow the business, and the value of the company would only be reflected over a multi-year growth journey. Investors should, therefore, eschew the one-year horizon for the target price as it is too short-term driven.
Businesses Are Growing And Evolving
Ideally, I believe brokerage reports should eliminate the concept of a target price. It creates a distraction for the reader as the time horizon is too short, and the investor may also develop anchoring bias.
Businesses are like living organisms which grow and evolve, and their value would therefore also grow and change over time. Trying to encapsulate it in a single number seems foolhardy, and investors should instead purchase to participate in the company’s growth over the long-term.
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