When investing it’s easy to get bogged down in numbers. Whether it’s a simple price multiple like P/E or the input and output of a discounted cash flow analysis, numbers are the primary focus of most investors.
Judging by analysts reports the one number that rules above all others is the one year price target. That one number is supposed to accurately summarise hours/days or even weeks of research.
Of all the bullshit numbers, the 52 week price target, often predicted down to the cent, is the crappiest of them all. Yet it’s the one number highlighted in bold on the front of research reports.
Stock price targets make no sense
Price targets are a double dip of delusion. To think you can accurately predict the forward price of any stock to the cent or even within 20 percent is crazy, you can’t. Worse yet, fundamental analysts focusing on a short time frame such as a year exacerbates the delusion.
I try to keep to it simple.
- Is this company meaningfully undervalued?
- How sure am I right?
- How large is the downside if I’m wrong?
- Are there good catalysts to send this company towards over-valued within a few years?
As I’ve said many times, I utilise both the market weighing and voting machines. I seek the twin turbo charge of increasing value and multiples. I want the weight and popularity of a company to increase. That’s my path to market outperformance.
Price ranges make more sense
I mentioned Nearmap (ASX:NEA) is my last post. I like it’s growth prospects, sticky recurring revenue and leverage. So here’s an example of how I think about price
targets ranges and returns from my investment in Nearmap.
Each of the five rows in blue display possible prices for 1 to 6 years hence — my sweet spot in investing is circa 1-3 years. The two green rows at the bottom show the total and annual compounded returns for the middle/bold row above (average range).
The price ranges are based on multiple valuation methods such as dividend discount, discounted cash flow, return on equity or price multiples. Each method is a different tool and works better or worse depending on the company. I choose a combination I consider most appropriate for the company in question. For Nearmap that’s DCF and price earnings multiple derived from projected profit and loss statement.
Wow, it’s starting to sound like I get bogged in numbers! But that’s far from the truth. If you run into me on the street or in a cafe, I would not be able to tell you my price range for Nearmap. Heck most days I couldn’t even tell you its current price (it’s fifty something…right?) as those sort of details are almost meaningless to me. But I could say it’s probable Nearmap will thump the market over the next few years and has the potential for excellent long term returns.
As I’m long Nearmap I probably wouldn’t tell you about the downside — the execution risks and the competition. However I will tell you this, next year’s earning may well disappoint a few investors and that could provide an attractive entry point. But I’m not prepared to speculate on that, so am both long and living in hope that next years earnings do disappoint so I can opportunistically buy more.
Garbage in garbage out
The main reason I do valuations is not for the price output, but to examine the inputs. Can the company grow sales that fast? Will the industry support those sales? What will margins look like? Can the company self fund?
I view valuation as a tool to help me think more deeply about a company and its prospects, rather than a tool to output a single target price or even a price range.
Circling the wagons
Circling back to the fours questions I posed earlier. The two times I bought Nearmap it was meaningfully undervalued and I had a high conviction. The valuation gap is now smaller, but Nearmap does have excellent long-term potential.
When I bought there was limited downside due to the strong, sticky and growing Australian revenue stream. With Nearmap’s US expansion and price increase there is now both more upside and downside potential.
Nearmap is a catalyst rich company that could easily provide the twin turbo charge I seek.
Disclosure: Obviously long NEA.