FOOL ON THE HILL
An Investment Opinion
The Unbearable Silliness of Price Targets
Bill Barker (TMF Max)
October 28, 1999
I had the pleasure of speaking to an investors' group at the University of Maryland last week, and during the talk I discussed the advantages of reading analyst reports, while cautioning about the dangers of an investor paying any attention to analyst ratings ("buy," "strong buy," "accumulate," etc.) or "price targets."
The audience was perhaps a little confused by this, as at least some may have thought that the rating and price target were sort of the "bottom lines" to the analysis. I don't really think that's the case. As we've said elsewhere, there's often a lot to learn from reading the analysis in a report, but the buy ratings, and especially the "price targets," are not really there to serve an investor. Let me give an example.
About a month ago, on September 29, 1999, Prudential Securities produced a report on TheStreet.com (Nasdaq: TSCM) entitled, "Initiating Coverage of TheStreet.com With A Strong Buy Rating And A $30 Price Target." (At the time TheStreet.com traded at $20 a share.) For the most part, the report and analysis are fairly standard. The authors provide a brief history of the company, a few numbers about the attractive demographics of TheStreet.com's readership, and a declaration that the company "has established an outstanding reputation for financial commentary." Nothing too controversial in any of that.
The report concludes, "Our target price of $30, which provides 50% appreciation from the current level, is based on an enterprise value of 25 times 2000 revenues, which could prove conservative if the company's multiple reaches or exceeds its peer group's current multiple. Thus we view it as conservative and note that there could be upside to our target price." (Enterprise value is the market capitalization of a company minus its cash and cash equivalents plus its long-term debt.)
"A-ha," the reader of the report is supposed to say to herself. "Here is a company that a fine Wall Street brokerage says, conservatively should be valued 50% higher than it is right now. They give proof! The companies most like it, its peers, already trade at such a multiple. This must be money in the bag. The market is simply asleep at the wheel, and through diligent research Prudential has dug up this fine nugget of truth, passed over by the market. I get to buy a $30 stock for only $20 a share. That's so cheap, I can't afford not to buy."
We then turn to the proof. The report provides a chart of what is, according to Prudential, the peer group of TheStreet.com. The comparable companies offered are Go2Net, Marketwatch, Multex, TheGlobe, CNET, Xoom, Excite@Home, America Online, and Yahoo!.
I figure that these are useful companies to provide a backdrop for how TheStreet.com should be valued as long as you assume that the likely readers of your analysis are complete idiots. Any reader with at least two brain cells engaged is going to look at this grouping and say to himself, "Just how stupid do these guys take me to be?" Rather than go through an exhaustive list of the dozen or so problems with the grouping, let's look at three of the more critical sleights of hand being perpetrated here.
1. The Street.com has, by far, the lowest revenues of any company in the "group." Frankly, nobody who was taking the matter seriously would group a company with $13 million in revenues this year (TheStreet.com) next to a company with $5.6 billion in revenues (AOL) as a "peer." If you want a true peer group for TheStreet.com on the basis of its sales, you need to find companies for which TheStreet.com is in the middle of the group, not at the very bottom.
2. Three of these nine companies (AOL, Yahoo!, Go2Net) are currently profitable, and two others (CNET, Excite@Home) are expected to be next year. Not surprisngly, these five are the companies which have dramatically higher enterprise value multiples. The profitable or soon-to-be profitable companies as a group have an average enterprise value multiple of about 31x calendar year 2000 revenue. Excluding TheStreet.com, the four "peer" companies selected by Prudential which, like TheStreet, are not expected to be profitable in 2000, have an average enterprise multiple of 11.6x CY2000 revenues -- actually lower than TheStreet.com's 12.9x multiple at the time the report was written. Though Prudential fails to make this distinction, the market clearly does not.
3. The companies selected don't really do anything remotely similar to each other. (While I wasn't paying attention, did TheStreet.com become an ISP? Is it into broadband access?) At best, the peer group could be called, "Internet companies," conveying the notion that any nine Internet companies are pretty much the same as any other nine. More accurately, the group could be called, "among the very best Internet companies, plus a few pretty iffy operations." I don't know how many people, other than a Wall Street analyst, would call that a peer group.
If you really want to get a look at a "peer group" for the Street.com, you'd select similarly sized companies in terms of revenue, which do roughly the same type of business, and are at about the same stage of profitability. I think you'd come up with something vaguely like this (your mileage may vary):
($ in millions)
Market Cap EPS Revenues Multiple
FY99 FY00 CY98 CY99 CY99
SportsLine USA 742 -2.60 -2.32 30.5 58 12.8
About.com 604 -5.34 -3.56 3.7 23 26.3
Multex 385 -0.76 -0.29 13.1 35 11
Marketwatch 791 -2.96 -3.10 7.0 23 34.4
MapQuest 501 -0.44 -0.36 24.7 31 16.2
iVillage 712 -4.38 -3.72 15.0 36 19.8
Hoover's 130 -1.26 -0.48 7.9 14 9.3
TheGlobe.com 305 -1.25 -0.88 5.5 20 15.3
Xoom.com 951 -1.32 -1.54 8.3 30 31.7
Average 568 13 29.8 19.7
TheStreet.com 470 -1.38 -1.48 4.6 14 33.6
As you can see, TheStreet.com still has the lowest revenues of this group -- but at least it's a lot closer. Since, unlike TheStreet, a couple of these peer companies are expected to be profitable as soon as 2001, this list might still be considered generous, but certainly not overly so. After all, it includes TheGlobe.com, and though I wouldn't have thought that TheStreet's worst enemy would have included TheGlobe.com as a comparable company, I've followed Prudential's lead in tossing it into the grouping.
You can break down these numbers in all sorts of ways, making various assumptions about the level of sales for next year for each company. (As a group, these companies are expected to roughly double their revenues for 2000 over 1999. TheStreet, because of its smaller revenue base, might be expected to grow slightly faster.) What you'll probably wind up with is that TheStreet.com today is about fairly valued on an enterprise value basis as compared to its true peer group on the year forward revenues metric. But under no circumstances, no matter how aggressive and optimistic you wish to get, will you ever arrive at the conclusion that comparable companies indicate a 50% price appreciation if TheStreet were to trade more like its true peers.
Look, this is not a stealth attack on TheStreet.com. I don't think the reasons to like, not like, buy, sell, hold, or accumulate the company have anything to do with comparing its year forward sales to the market multiples on the revenues of Yahoo! or iVillage. The Street.com might very well be worth $30 a share (in a recent Dueling Fools debate Brian Graney supported the notion well), but if it is, it isn't because the companies that look most like it have an enterprise value of 25x next year's revenues. They simply don't. They trade at an enterprise value of about 10-12x next year's revenues -- just like TheStreet.com.
So why did Prudential's analysts go as far out of the way as they did, supplying totally bizarre companies as "peers"? Why did Prudential's analysts supply a report that, if handed in to any business school professor in the country, would have been returned with a circled "F" on the front page?
Because they had to. By the rules of the Wall Street analyst game, there has to be a price target accompanying these reports, and it has to generally be based on something. It doesn't have to be based on something the analyst actually believes or would defend in a debate; it just has to have some vague support. In this case, there was, one assumes, no better way to produce a sufficiently high price target to accompany a "Strong Buy" rating -- and a Strong Buy rating needs, under the rules of the initiating coverage game, a high price target.
That may be silly, that may be unhelpful to clients, and that may produce results that work better as comedy than analysis, but that's why Fools should learn to ignore analysts' price targets.