Wednesday, May 13, 2009

Arbitrary price targets and up/downgrades.

Details of Abercrombie upgrades over the last few days, from the AP (http://finance.yahoo.com/news/Ahead-of-the-Bell-Jefferies-apf-15227466.html/print):

"It's time to look at Abercrombie again," Randal Konik wrote in a research
note to investors. Konik also raised his price target on the shares to $35 from $22.
"While we expect continued near-term sales/margin pressure, we believe the earnings revision cycle has reached a trough," Konik wrote. The Jefferies upgrade came one day after KeyBanc analyst Edward Yruma also upgraded Abercrombie shares, to "Buy" from "Underweight." Analyst Edward Yruma also raised his share price target to $32 from $17."
Really? The revisions are slowing/stopping, and the company is now worth DOUBLE what is was a day before? This is an example of the arbitrary nature of many stock price targets, and the reasoning behind them. Please, at least have a bit more stable valuation measure. Maybe arrive at a company's worst case earnings scenario and place a lowball target on that. Or a normalized earnings/FCF level. But trying to gauge "sentiment" and the the "trough" is simply too tough. A worse example is a 2008 downgrade of the tower companies (AMT,CCI, SBAC) by a firm that will remain nameless. They listed the following as reasons:
  • leverage giving rise to liquidity and refinancing risk
  • potential slowdown in carriers' network buildout plans
  • rising cost of capital from higher equity risk premiums
A few thoughts. "liquidity and refinancing" risk are not baked into long-term DCF models, whose cheap WACC (debt-heavy Weighted Average Cost of Capital) make up the bullish investment case for these companies. Worse still, is that the analyst cites "higher equity risk premiums" as a reason to increase the firms' cost of capital. The stocks become more volatile (um, meaning cheaper in this case), yet the future cash flows are worth less because of the "equity risk premium." In SBAC's case the analyst dropped the price target to $23 from $41, likely due to tinkering with the cost of capital. I know it goes against everything we/you learned in corporate finance, but the Capital Asset Pricing Model is flawed - having debt should not make your future cash flows worth more than if you had zero debt - yet that's what the model demands.....

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