PREMIUM SEARCH Search by job title, geography and build a list of executive contacts
Here's a common quandary for investors: It stands to reason that a positive stock recommendation from an analyst should mean he or she thinks highly of the company's prospects. The price target on the stock -- the analyst's prediction of how high it will rise before an investor should cash in on gains -- usually matches that sentiment. Yet it happens quite often that a stock will have a positive or buy rating but a modest target price.
What gives? If investors fear Wall Street's system of rating stocks is muddied enough by potential conflicts of interest, a seeming mismatch between ratings and target prices only adds to the confusion. While systems differ from firm to firm, typically a rating of strong buy means the analyst thinks the stock can yield a return of 20% or better. A buy rating implies around a 15% return, and a hold-rated stock is expected to move with the market at best. But a price target that varies dramatically from a rating could be an analyst's way of sending a subtler message, experts say (see BW Online, 4/25/02, "One Way to End the Analyst Scandals").
Deciphering that message can be tricky, but it's not impossible. "There are good and bad reasons why that [disparity] can happen," says David Robertson, an analyst with Allied Investments. If a stock is trading just short of an analyst's price target, it may be a sign that the analyst is not especially enthusiastic about the company's prospects, even though the analyst still gives the stock a positive rating.
"BETWEEN THE LINES." "The price target is where analysts can maintain their integrity," says Michael Farr, president and chief investment officer of Washington-based investment adviser Farr Miller. "It's a way for investors to read between the lines," he says.
Of course, even to the naive investor, it became all too obvious in recent years why an analyst might have a strong buy rating on a stock that doesn't necessarily merit it. "In some situations, it's clear that the company is a banking client" and the cheery rating is a way to keep favor, Robertson says. In other instances, a contradiction could indicate that an analyst thinks a company has solid fundamentals but that its stock is overvalued.
Take a look at Lehman Brothers' Apr. 19 report on technical-services concern Jacobs Engineering Group (JEC
). Analyst Don Zwyer rates the stock a buy and says Jacobs' fiscal second-quarter results were better than expected. He thinks it should show "consistent and predictable" growth over the long term. However, despite the rating, the analyst doesn't recommend investors go out and purchase the stock at current prices. Instead, he concludes that investors should "buy on weakness."
PREVENTING PANIC. Essentially, Zwyer's rating reflects an overall favorable stance, but the price target says he thinks the stock is overbought. While the stock trades around $40 per share, his target price is $35, a difference of about 14%. Zwyer says the shares have been volatile since a 2-for-1 split on Apr. 2. "The stock has gone beyond our target every now and then, and then it has come back down. But our 12-month expectation for it is $35."
In other instances, the explanation for the mismatched price target and rating is more benign. "The analyst may be thinking that the fundamentals are so strong that earnings expectations need to be increased soon," says Farr. And sometimes, analysts will have volatility in mind when a stock gets close to or exceeds a price target because changing the rating or the target price can trigger panic among investors.
Indeed, for just that reason many analysts won't change a target price on a stock they think is fundamentally strong when its price nears or surpasses the target. Particularly with small-cap stocks, lowering the target can create a seesaw effect, says Jim Miles, co-manager of Hotchkis & Wiley Small Cap Value fund. "There are some practical considerations when you change your recommendation or target price. Even if a stock price gets ahead of or close to target valuations, a downgrade could signal some negativity," Miles says.
EROSION OF TRUST. Market forces also play a role in analysts' willingness to set high price targets. According to First Call/Thomson Financial, which tracks and analyzes estimates and recommendations, the majority of stocks today are still either rated buy or strong buy.
However, market volatility, especially since September 11, has sometimes made it hard for analysts to make the right call. The erosion of trust after Enron's collapse also has some analysts holding their tongues. "These securities analysts operate within the overall market," says Patrick Gregory, professor of finance at Bentley College in Waltham, Mass. "Movement of the market in many cases can drive [their] recommendations."
The years since the bursting of the tech bubble haven't been kind to hyper-bullish stock gurus. Certainly, Henry Blodget-style projections for 200% gains in high-risk technology stocks are no longer in vogue. Price targets are more conservative, reflecting far more precarious market and investor sentiment, says Chuck Hill, director of research at First Call.
STRONGER WALLS? Still, he worries that targets are all over the map. "The surprising thing is how wide the range is," Hill says. "We still have some people out there who believe that we're going back to a market like the late '90s. We still haven't shaken all the excesses out yet."
Against this backdrop, ongoing discussions about how to prevent stock research from being tainted by the interests of a firm's investment-banking division have a lot of analysts more mindful of how they appear to their clients. Since the end of the dot-com craze, plans have emerged to strengthen the wall between research and investment banking.
The latest signal of the ongoing backlash is New York State Attorney General Eliot Spitzer's investigation of the relationship between the units at Merrill Lynch and other Wall Street giants. Those firms maintain that they've done nothing wrong, although an industrywide move is afoot to make sure analyst ratings can be justified by a company's fundamentals.
WHERE THE MEAT IS. It the end, stock ratings and target prices are just the skin and bones of analysts' research. The meat of such reports is in the analysis, details, and tone. Investors who are willing to spend the time can easily figure out what an analyst really thinks about a stock by reading a research report. And although it can be tough slogging, a company's own filings to the Securities & Exchange Commission are filled with revealing information about prospects for sales and profits.
But when looking at Wall Street's two most common measures of a stock's attractiveness, investors always want to dig deeper if there's a disconnect between the rating and the price target.
Tsao covers financial markets for BusinessWeek Online in New York Edited by Beth Belton
Get BusinessWeek directly on your desktop with our RSS feeds.
Add BusinessWeek news to your Web site with our headline feed.
Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video.
To subscribe online to BusinessWeek magazine, please click here.
Copyright 2002 , by The McGraw-Hill Companies Inc. All rights reserved.
Printer-Friendly Version
