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Ask The Expert: Should You Listen To Analysts' Stock Price Predictions?

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From the world's top hedge fund managers to the local financial advisor, you'll hear a similar refrain: "I never use Wall Street research. It's not worth the paper it's printed on."

These folks will tell you that analysts have become lazy and rarely pursue "outside the box" thinking when it comes to assessing the changing dynamics in the industries they follow. Indeed, their profit forecasts are often derived from the guidance given by companies, which is why you'll often see the same eight or 10 analysts following a company with almost the exact same earnings per share (EPS) forecast for the year ahead.

Sadly, the analysts that do show a great deal of creativity -- and accuracy -- in their assessments quickly get scooped up by the hedge funds and mutual funds, and the ones that stay put are not always considered to be Wall Street's leading thinkers.

Which all leads to today's question.

"Do price targets matter, and if so, how should I use them?"

        ----Eric R., Alpharetta, Ga.

A price target is an analyst's expectation for the future price of a security.

First, let's look at how analysts determine price targets. They predict what a company's profits will be in the next few years, and then they determine an appropriate price-to-earnings (P/E) ratio for those profits. The EPS forecast multiplied by the merited P/E ratio yields their price target.

Here's the problem…

These analysts are very conservative in their approach and rarely deviate from the pack. Indeed, they express little interest in the long-term trends impacting a business, and they often miss the opportunity to boldly issue a much higher (or lower) price target than their peers.

Instead, these analysts simply watch the action and then, every few months, they make subtle adjustments to their price targets and forecasts. And it's this kind of myopia that can be unhelpful when trying to find stocks with big long-term upside (or downside).

Many price targets simply reflect what business is likely to look like in just a quarter or two. And who really cares about that?

Yet there is one instance when price targets do matter: the outlier.

If nine analysts following a company all anticipate forward EPS of around $2 and have $24 price targets, but the 10th analyst has a much different view, I want to know why. Chances are this analyst has dug more deeply into the company's operating trends, and the resulting analysis of EPS and price targets holds a great deal of validity.

In a perfect world, analysts would base their price targets on their outlooks for two or even three years down the road. For example, automakers Ford (NYSE: F) and GM (NYSE: GM) have announced plans to refresh their entire product lines over the next 30 months, which is quite aggressive and should give these firms a real boost when it comes to showroom traffic.

How have analysts responded? With a wait-and-see attitude.

With each passing quarter, as new cars and trucks roll into the showroom and onto customers, these analysts will slowly raise their price targets.

The Investing Answer:  Price targets are often of little use, except when you come across a target that skews far from the consensus. Of course, there's a chance that this analyst is using faulty or overly aggressive assumptions in future forecasts, but those analysts don't tend to last in the business very long. 

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