Why do analysts decide on a target price for a stock that is lower than its current price?
I am a beginner investor. I don't understand why analysts decide on a target price for a stock that is lower than its current price, versus a higher estimate that would bring in more profit. I know that analysts can create a mix of both Bull-ish and Bear-ish opinions of a stock value, but I have trouble understanding why a low share price is more profitable than a share selling for a high price. Am I forgetting that a lower target price is for Bear-ish and day trading investors who want to save money rather than make money? Am I failing to consider the importance of why a stock might be undervalued or overvalued, in addition to its time horizon, when considering its target price? What am I missing?
An analyst’s “target price” is his/her best estimate of a stock’s future price. Since the stock market is an auction where buyers and sellers transact business, the analyst is trying to determine a solid estimate of future price based on company financials, industry trends, and economic factors.
Analyzing stock prices is not an exact science. Ten different analysts will arrive at ten different target prices depending on each one’s weighting of various factors. For traded stocks, they should each be starting with the same set of public financial data, but that entails a hundred or thousand data points for each stock. Plus, each analyst will apply their own process, experience, and judgment to that data.
Additionally, at least part of a stock’s value lies in future (estimated) data. Financial records necessarily look backwards, but the value to a new buyer lies in the company’s prospects. Will sales grow faster or slower in the future? Are margins in the industry rising or shrinking? Does the company have any product innovations in the pipeline? How about their competitors?
So, setting a target price is a judgment call. An informed analyst weighs all the past and future data with their own personal knowledge of the company and industry. From this, they set a target that they expect sometime in the future. Buyers or sellers can then use this target for their own decision-making about the stock.
Let’s say that a certain analyst sets a target for ABC stock at $25 per share. The stock is trading today for $20 per share. If you think this analyst is credible, then you might choose to buy ABC because you could make $5 per share (a whopping 25%) when the share price hits that target (again, timing of that price change is an estimate, too). Or if you question this analyst’s credibility, you can search to see what other analysts estimate for ABC before deciding.
An analyst sets the future target price with little regard to the price today. So, they might set a target price for ABC at $15. If you find that analysis credible, you’d probably decide to wait before buying (until the price falls to $15 or less) or sell if you already own it. Again, this is just one person’s judgment about the future price. You can use the information however you choose.
Importantly, really importantly, no one knows what will happen next with stock prices or any company. The fact that someone is an analyst following a stock does not make them right. They are simply an informed party doing their best to understand the company and landscape. Even the best analysts will be wrong sometimes.
As an investor, you are the final decision-maker. Learn as much as you can, choose credible people or companies for information, and exercise your own judgement when buying or selling. There are a million moving parts and it is impossible to predict the future.
Dear Beginner Investor,
I hope that I am following all of your questions, but I think it is best to answer your question by explaining how analysts determine their target stock price. Forget publically traded companies for a second, and consider that you were going to buy a local private company. To determine how much you're willing to pay for that company, you are going to look at top line (gross sales) and bottom line (net profit) growth. Then you will take that expected earnings and multiply it by some factor. If the company is growing really quickly then the top line probably looks great, but the net profit may look a little slim. You want in though, because you believe in the potential and you see how quickly they are growing. As such, you are willing to pay 30 times the net profit. Now you've invested in a growth stock. If the company is not growing really quickly, but they have strong cash flow, and they're willing to pay you a nice dividend check then maybe you're willing to pay 10 times the net profit. Now you've invested in a value stock. The 30 times and 10 times profit is made up in this example, but publically traded stocks have other companies like them so you look and see what multiple other investors are willing to pay for their companies when looking at yours.
Analysts will look at a company's prior compounded annual growth rate to see how successful they have been in increasing revenue. Then they will look at the big picture and see what might influence this market. Is there a new competitor? Is there an expectation that the widgets they are making are going to cost more because of a global shortage of material and that will squeeze their profits?
An analyst will provide a target price below a stock's current market price if they believe the stock will fail to deliver the growth required to justify that high price (i.e. the high multiple investors are willing to pay for profits). So yes it would be fair to say they are bearish on that stock in the short-term, but you will often see analysts continue to adjust target prices as companies continue to grow and expand. If a stock is considered overvalued and you want to buy some shares, then figure out how much you want to invest then invest maybe 1/3 of that amount. Companies that are overvalued have very little to no margin of safety which means you are likely to experience volatility.
You also mention that you are having trouble understanding why a low share price is more profitable than a share selling for a high price. If you are comparing two companies and Company A is selling for $10/share and appears to be profitable, but Company B is selling for $50/share and doesn't appear to be profitable then you are making a comparison you shouldn't. Company A may be selling for $10/share but has 500 million shares outstanding which means they have a market cap (outstanding shares multiplied by price per share) of $5 billion. Company B may be selling for $100/share but have 10 million shares outstanding which means they have a market cap of $1 billion. Company A is five times as valuable as Company B even though their share prices are flipped.
Hopefully that helps you!
The short answer is that the analyst believes the stock is overvalued, and the lower price target better reflects the company's future earnings potential. A stock's price is the sum of all future earnings, discounted back to the present with a discount rate that reflects the risk (uncertainty) associated with the investment. The higher the discount rate, the lower the current price "target". High risk investments require high returns to justify the risk, and are discounted at a higher rate. Therefore, an analyst that sets a price target lower than the market believes that the market is using a discount rate that is too low. Hope this helps!