Why you need to know the difference between target price and intrinsic value
Analysts at investment banks and broking firms regularly issue a Target Price for the companies they follow. At Montgomery, we prefer to look at the Intrinsic Value of a business. There’s a key difference between the two metrics, which some investors may not understand.
A Target Price has come to represent the expected share price in one year, typically derived by ‘rolling forward’ a valuation by 12 months. The Target Price contributes to the consensus view of a company’s value.
In contrast, a company’s Intrinsic Value is the present value of all expected cash flows.
For simplicity, let’s say a bank offers a listed instrument with an interest rate of 5% for only one year. After one year, the instrument is closed down and the funds are returned to investors (there are no ongoing cash flows with this example). So if $100 is invested today, $105 will be distributed in one year’s time.
If we assumed our required return on investment was 5%, then the Intrinsic Value of this product is $100 ($100 principal plus $5 of interest, discounted at 5% for one year). But if market analysts follow convention with this example, they would report a Target Price of $105.
Now let’s say that this listed product was trading at $103. If our Intrinsic Value is $100 then we are better allocating our capital elsewhere. But if we mistake the Target Price of $105 for its Intrinsic Value, then we would be forgoing $3 of potential returns. Or put another way, the return on that investment would be 2%, which is below our required return of 5%.
Analysts will typically include a valuation range in their research reports alongside the Target Price. But as these aren’t reported with consensus ratings you must be careful when using them as a reference for your own analysis.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
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Dave
:
Hi Ben, what is the estimated intrinsic value of a unit in the Montgomery Fund?
Roger Montgomery
:
Great question. The current value of the portfolio is not too far from its current price.
Nelson
:
Hi Ben, reading over your post (maybe once or twice), wouldn’t you expect a good analyst to roll a valuation forward using an intrinsic value approach to arrive at a Target price? What is generally the approach / methodology used?
Also, to play devils advocate, your example refers to a Target price of $105, but that would seem to be on a on pre-distribution basis, meaning potentially an investor would miss out on $5 interest and return of capital of $100 at the end of year 1?
Ben MacNevin
:
Hello Nelson,
Analysts on the sell side typically generate both intrinsic values and target prices in their research reports, yet they will favour the target price when providing a value for consensus estimates. This tends to inflate the perceived opportunity.
So in relation to the above example, if an investor compared the share price of $103 to the Target Price of $105, they may deem that an opportunity exists. But if they instead referenced the Intrinsic Value of $100, they would conclude that their capital could generate higher returns elsewhere.
Paul
:
Hi Ben, I understand how an analyst can view the latest reported financials and come up with a value or opinion but how do they actually forecast future earnings. Is it looking at past performances to get a trend in earnings or alternatively ignoring the past and guessing the future; is it talking to management or other analysts, a bit of crystal balling perhaps or a blend of all of the above?
Ben MacNevin
:
Hello Paul,
Your question prompts an extensive answer, but perhaps I can best frame it in the way we invest. Our philosophy is to invest in quality companies with bright prospects at a discount to intrinsic value. This requires both a historical perspective (understanding the quality of earnings) and a future perspective (what returns can it generate on deployed capital). Many sources can help assess future prospects (industry structure, management commentary, competitive advantages, regulatory change, demographics) – but simply guessing is analogous to speculation, rather than investing, which we’re not in the business of.