Target Practice

Of all the questions asked of me about investing, one of the more common ones these days concerns target prices for stocks, specifically whether I use target prices in my investment work. Whenever stocks have moved up significantly, as they have in 2013, investors start thinking about whether they should cash in their gains, and so they go looking for some sort of signal or talisman to tell them that a particular stock or the market as a whole has reached a level from which no further advance is probable. It would be nice, of course, if such a foolproof indicator existed, but there really is no such thing. The short answer to the question is, yes, I use target prices, but the question reminds me of the one about the dog that habitually chases cars: What would the dog do with a car if he caught one? So, today we'll consider how investment analysts arrive at target prices and whether hitting that target should cause us to take any action. The question, then, is okay, So Now What?

What a target price implies, assuming that it is higher than where the stock is trading, is that some sort of fundamental analysis indicates that the stock is actually worth more than its current market price. You certainly wouldn't want to buy a stock at $50 per share if the analysis suggests it is only worth $40. So, where does someone come up with the $40 value? There are at least a couple of different approaches. Investors who follow a strict value discipline typically arrive at a stock's intrinsic value by analyzing the company's sales, profit margins, earnings, cash flows, assets and liabilities. This is the approach you would take if you were buying a business outright--value investors approach it in precisely this way, valuing the entire enterprise as if they were going to buy it lock, stock, and barrel. If the stock is trading at a big enough discount to this intrinsic value, it becomes a buy candidate.

Two years ago shares of Disney (DIS, $65) were trading around $30 per share, and it appeared to be a situation where the "sum of the parts" was greater than the whole. That is, if you examined and valued each of Disney's assets--the theme parks, movie studios, the ABC television network, Marvel, Pixar, and ESPN--and then added it all up, you would arrive at a figure substantially higher then $30 per share. One analyst noted at the time that ESPN alone was probably worth more than $20 a share. In this case, the company's intrinsic value is not exactly or necessarily the same as a target price, but it functions in the same way because once a stock reaches its intrinsic value, it no longer holds the appeal it once had for true value investors. The target prices I've seen published for Disney today are in the $75 range, which implies a potential upside of about 15% from the current stock price. Another example is Scripps Interactive Networks (SNI, $77), which is the company behind the Food Network, Travel Channel, and HGTV, collectively  known as "lifestyle-oriented content." In a recent Barron's article, one money manager contends that the company should be worth about $90 per share based on EBITDA valuation, while another analyst suggests it could be worth worth around $98 to $100 per share if another media company were to buy it (known as "private-market value"). I would never recommend buying a stock on takeover speculation alone, but here you have a company that offers value even without a takeout.

Arriving at target prices for growth stocks typically involves a more explicit focus on future earnings. Celgene (CELG, $147), the biotechnology company, said back in January that the company should earn around $5.50 per share in Fiscal Year (FY) 2013 and expects to earn $13.00 to $14.00 per share in 2017. Now, that is some serious growth, if they can achieve it. The highest price target I can find for CELG now is $172 per share. If we do a little "back of the envelope" math, we might apply a multiple of 20 to those future earnings for a potential price of around $280. So, why is the current price target not higher? Well, for two reasons. If you read the fine print, you'll see that those published price targets are typically based on a 12-month time frame. The other reason, though, is like the family going on vacation where the kid in the back seat keeps asking, "Are we there yet?" Well, no, we are not there yet, and that is the point. The year 2017 is more than three years out, and a lot can happen--both good and bad--between now and then. The longer the time frame, the greater the uncertainty. It is this uncertainty, though, coupled with the company's potential, that gives investors the opportunity. Would I sell Celgene if it reached $172 before the end of this year? No, because my time frame is much longer than that. That doesn't mean the target price is worthless, because it is good to know that the analysts who follow the stock closely don't see it as currently overvalued. What if Celgene reached $280 per share within the next few months? Depending on the circumstances, we might conclude that the stock had "gotten ahead of itself," which would suggest that the market has taken all of that future potential--and all of those potential future earnings--and factored them into the stock price today. That would still not be, in my view, a reason to automatically sell the stock. I will sell a stock if the reasons for owning it in the first place no longer hold true. Accordingly, I will be following the news on Celgene very closely to see whether they can stay on track, how their clinical trials are going, and information about any new drugs in their pipeline. If there are any material changes or disappointments, I'll have to reevaluate. For now, I'll just say that I hope I still own this stock in 10 years.

We'll also note here that target prices are not static, or at least that we don't want them to be. I love it when investment firms raise their price targets on my stocks. If an analyst has the strongest available buy rating on a given stock, then about the only way that he or she can "pound the table" any more forcefully is to raise the target price. Such increases are often accompanied by a ratcheting up of earnings estimates, and that tends to occur after a company has reported much stronger than expected quarterly earnings. We saw this in the latest earnings season with Starbucks (SBUX, $75), Michael Kors (KORS, $75), and Facebook (FB, $47), to name just a few. The point here is that we want to use target prices to our greatest advantage, but we don't necessarily want our decision to sell a stock to be governed by a view of the company that is much more short-sighted than our own.

Life is short. Get busy.

Jim

Disclosure/ Disclaimer: My family members and/or I own shares of DIS, SNI, CELG, SBUX, KORS, and FB. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.