We all wish we had a crystal ball to aid our investing. After all, knowing what the future holds in the markets would enable us to very quickly rack up the kind of returns which would allow us to retire to our own Caribbean island.

So, it’s no surprise people are drawn to analyst forecasts. These are estimates calculated by professionals working at stockbrokers and investment banks. They are seeking to determine what will happen to a company’s share price so investors can place trades and hopefully generate a positive return in the coming months and years.

Analysts are human beings, and these projections are inevitably imperfect. However, they can offer a useful guide and aid to research as well as providing the context for how the rest of the market perceives a company.

BUY, SELL OR HOLD

Generally, a piece of investment research on a stock will offer three things. A recommendation on the shares, a price target as well as forecasts for earnings and other items like dividends and cash flow.

Dealing with each of them in turn, the recommendation, while the most prominent piece of information, is probably the least important.

A note will instruct clients to ‘buy, sell or hold’. The accompanying price targets, signalling the level an analyst thinks the shares will hit within the next 12 months, will help determine the share price recommendation.

A buy tends to be when a broker believes the share price will rise by more than 10% from the current price over the next 12 months.

A hold is when they believe the share price will either rise by less than 10%, or fall by less than 10%, versus the current price. Sell is when they think the shares will fall by more than 10%.

The rules are subjective and vary from broker to broker in terms of the exact percentages used. You might also see ‘neutral’ – which is essentially the same as ‘hold’.

An alternative method is to rate a stock using ‘overweight, equal weight and underweight’. This is comparing the predicted share price performance of a company relative to its sector.

For example, a hypothetical software company called TechX might have an ‘overweight’ rating if the broker thinks it will materially outperform the broader software sector.

WHERE IS THE RECOMMENDATION COMING FROM?

Analysts produce research to provide investment ideas to their clients but are often, in effect, bidding for the business of the company which is the subject of the research.

Some research is issued by institutions which are already providing stockbroking or investment banking services to the firm in question – in these circumstances they would often be termed the ‘house broker’.

They are unlikely to do anything to upset the apple cart. As such sell or, in the case of a house broker, hold recommendations are probably the most interesting.

It could just be the case that an analyst thinks the shares are overvalued but if there is a specific failing or risk associated with a company which they think the market may have missed that warrants further attention.

Some house brokers take the view that it would be inappropriate for them to have a ‘buy, sell or hold’ rating on a company which is also paying them for broking services and employ a ‘corporate’ rating instead.

BUILDING THE FORECASTS

Underpinning the headline recommendation and price target are the forecasts for earnings per share and other metrics.

Analysts build financial models that forecast a company’s growth and profitability. They look at sales rates, costs, opportunities, threats and more to get a sense of underlying growth trends.

The market uses these earnings forecasts to measure the appropriate value for a stock. Investors look at a company’s expected earnings power and work out how much they are prepared to pay to own its shares.

In the short term analysts often rely on guidance from businesses themselves to build forecasts but longer-term estimates and the way they value the shares will often involve building assumptions on future cash flows into a spreadsheet.

Tweaking their forecasts for future oil prices, in the case of an oil and gas producer, or factoring in the potential for acquisitions can have a huge impact on where analysts get to with their valuations.

COMING UP WITH A PRICE TARGET

The slightest change to a figure in a spreadsheet means price targets can be wildly at odds with those of other analysts and often with the share price of the company.

For example, Liberum recently started covering online reviews platform Trustpilot (TRST) and assigned it a 210p target. This is more than double the current market price after a big slump in the value of the business.

Analyst Ciaran Donnelly reckons the market is missing the revenue opportunity to convert non-paying users of Trustpilot’s platform to its subscription services.

The table shows how Liberum calculated its price target. As Trustpilot is not yet profitable, it incorporated what multiple of its sales the company ought to be trading on, by comparing it to similar businesses. Liberum also employed what’s called a discounted cash flow calculation – determining what the business is worth based on expected future cash flows.

Naturally there is a risk analysts become overly optimistic and slow to recognise when something has gone wrong. Equally they can also be overly pessimistic and blind to signs of improvement with companies that have experienced a lot of problems.

However, in the absence of alternatives the analyst community does at least provide a framework for how stocks can be valued by the market. 

Where to get the research

Broker research is typically not freely available to the public, but snippets do regularly appear in the financial press, including in Shares.

A good selection of research notes for smaller companies can be found on ResearchTree’s platform for a fee. You can also find consensus earnings forecasts on paid-for services like SharePad and Stockopedia.

A legislative framework called Mifid 2 has made it even harder for retail investors to get hold of analyst notes as there are tighter restrictions on who can read them.

That has led to a proliferation of research notes that are commissioned by companies themselves and links are often available via regulatory news service providers or directly from the companies being analysed. The non-independent nature clearly impacts the impartiality of the research, but they can still be a source of helpful information.

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