Academic journal article Accounting Horizons

The Use of Target Prices to Justify Sell-Side Analysts' Stock Recommendations

Academic journal article Accounting Horizons

The Use of Target Prices to Justify Sell-Side Analysts' Stock Recommendations

Article excerpt

SYNOPSIS: This study examines a sample of 103 sell-side analysts' reports to document the frequency with which analysts disclose target prices as justifications for their stock recommendations. In addition, I investigate whether the degree of assessed overpricing or underpricing implied by target prices is related to the favorableness of stock recommendations. I find that analysts use target price justifications in over two-thirds of the sample reports, and higher target prices are associated with more favorable stock recommendations. The most favorable recommendations (and target prices) are more likely to be justified by price-earnings ratios and expected growth while the least favorable recommendations are more likely to be justified with other qualitative statements. Further evidence suggests that analysts actually compute target prices using price-multiple heuristics such as "PEG." However, in reports that do not disclose target prices, estimates of target prices based on these heuristics are unable to j ustify the stock recommendations. Several explanations are proposed, including self-selection biases implying analysts do not disclose target prices when the disclosure would not support the recommendation or when analysts are less certain about underlying earnings forecasts.

Keywords: target prices; valuation; stock recommendations; earnings forecasts; sellside financial analysts; long-term growth; price-to-earnings ratios; PEG.

INTRODUCTION

Sell-side analysts presumably derive stock recommendations based on their own valuations of stocks. This study investigates the frequency with which analysts disclose these valuations in support of their stock recommendations and examines the properties of those valuations. A casual reading of analysts' reports reveals that they often mention valuations as "target" or "objective" prices, and the associated recommendations are supported by the difference between the target prices and the current trading prices. For example, CIBC Oppenheimer issued a report on Harcourt General when the price was $49.75 and concluded, "We continue to recommend Harcourt General with a price target of $64 per share. We believe that the stock is significantly undervalued at current levels." (1) The target price reflects the analyst's valuation of the stock, and it justifies the Buy recommendation in the report as one might expect.

Accepting the standard wording of recommendations, investors would expect that a Buy or Strong Buy recommendation indicates a stock that the analyst believes is currently underpriced, a Hold recommendation indicating a fairly priced stock, and a Sell recommendation indicating an overpriced stock. However, Sell recommendations are virtually nonexistent (Stickel 1998). Consequently, savvy investors might interpret Holds as essentially Sells, and Buys as Holds. However, would an analyst disclose a target price when he or she believes a company is overvalued? This may not be likely if previously documented optimistic bias in forecasts and recommendations also describes target prices (e.g., McNichols and O'Brien 1997). Explanations for this optimistic bias include a desire by analysts to "curry favor with management" (Francis and Philbrick 1993) and enhance investment banking relationships (Lin and McNichols 1998). To the extent that these incentives affect how analysts justify their recommendations, it is possibl e that there is an asymmetric use of target prices in support of stock recommendations.

Most prior research related to analysts' ability to identify mispriced stocks focuses on the stock recommendation, rather the analysts' valuations per se. For example, Womack (1996) documents significant market reactions to the release of analysts' recommendations, suggesting investors believe recommendations are valuation relevant. However, Bradshaw (2001) uses analysts' earnings forecasts as inputs into a residual income model, and finds that resulting valuations are unable to explain the associated stock recommendations, despite evidence that these valuations identify mispriced stocks (Frankel and Lee 1998). …

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