Wall Street Price Targets

While researching a company today, I bumped into a chart that included the stock price and the average Wall Street price target (chart below). It provided me with a good early morning chuckle. I’m sure most of you have seen similar charts and have noticed the same thing. Specifically, Wall Street price targets are often highly correlated to stock prices. If a stock goes up, the price target goes up. If a stock goes down, the price target goes down. Tell me the price of a stock and I’ll tell you what Wall Street believes the company is worth.  It’s a very reactive valuation process, and in my opinion, not a very accurate one. It’s one of the many reasons I avoid sell-side research.

The company in the chart above missed Wall Street’s earnings estimate last quarter. Shortly after the stock declined, Wall Street analysts adjusted their earnings models and lowered their price targets. Reactive target adjustments such as these are made frequently on the upside and downside.

In my opinion, the reason Wall Street price targets are so volatile is due to their valuation methodology. Most Wall Street analysts use an earnings multiple, such as P/E or EV/EBITDA, and apply this multiple to their earnings estimate for next year. For example, an analyst may value Company XYZ at 20x its 2017 earnings estimate. Simple enough, right? Right. But here’s the problem. By using next year’s earnings as the foundation of a business’s valuation, one year of profit is being used to value a perpetual asset with many years of uncertain profits.

Operating results and profits change from one year to the next. Sometimes earnings volatility is structural, while other times it’s simply a natural part of a company’s profit cycle. For example, the company in the chart above is experiencing a near-term decline in revenues and earnings. Such fluctuations in the company’s operating results have happened in the past and should be expected in the future. Over time, revenue growth and margins have evened out, with the company reporting some good years and some bad. Instead of taking normal fluctuations in operating trends into consideration, analysts that value businesses on near-term earnings are often more concerned about what is happening now versus what will happen over an entire profit cycle.

By properly accounting for the natural volatility in revenues, expenses, and other variables that influence full-cycle profits, I believe investors can produce a more accurate and less volatile business valuation. Unlike their underlying stocks, the value of most established operating businesses are relatively stable and change infrequently. In theory, intrinsic values should grow as profits and free cash flows are reinvested into the business. Business values can also change due to shifts in organic growth and improvements in the balance sheet. However, for mature businesses, these trends are typically gradual and should not change noticeably from one quarter to the next.

Below is an example of a chart I’d expect to see with a high-quality business over a two-year period. While its stock fluctuates with the market and company-specific news, the value of the business is stable and grows gradually. It’s quite a bit different than the average analyst price target chart above, isn’t it?

In conclusion, operating results and margins can and do fluctuate over a profit cycle. By considering these fluctuations in advance through the use of profit normalization, I believe investors can improve the stability and accuracy of their business valuations. A more stable and accurate valuation provides many advantages including a higher batting average (winners vs. losers), lower turnover, an increase in valuation confidence, and improved decisiveness. Moreover, normalizing just makes sense, doesn’t it? I think so. And that’s my goal when determining a business’s value. I want to value a business in a manner that makes the most sense to me, not Wall Street.