How Seriously Should You Take Price Targets?

Today on Industry Focus, we dip into the mailbag and tackle topics like analyst price targets, the best resources for new tech investors, and the hot-button issue of payment for order flow (PFOF) and how it affects incentives between brokers and market makers.

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This video was recorded on Oct. 8, 2021.

Dylan Lewis: It's probably October 8th and we're dividend mailbag. I'm your host, Dylan Lewis and I'm joined by fool.com's Jason Hall. Jason, how's it going?

Jason Hall: Happy Friday, my friend, I am ready to answer some questions from our viewers.

Dylan Lewis: Isn't as the best. When people right in and they're like, Hey, I'm interested in this because there are things that I think we are dying to talk about sometimes, but we don't necessarily know that will be interesting to our listeners or to our members, and so for people to say, hey, I want to hear about this, especially some of the chunkier stuff that we're going to get into on today's show. I always think it's such a treat. Be warned sometimes you can lead us down the rabbit hole [laughs] that's the thing, but that's half the fun. Managed. When I really go down there and I look up and my commitment staring at my phone for 30 minutes. It's humbling technology as a way of creeping in. We're going to be talking through three different topics on today's show. We're going be talking about price targets we are going to talk about payment for order flow, and we're also going to be talking about ways to get started as a tech investor. All of these coming directly from our listeners, and I have to put a plug out there if you ever have something that you want us to be talking about on the show, Industry Focus, at fool.com at MF, Industry Focus on Twitter. We love getting those ideas. Jason. This first one comes from Heidi. Heidi asks, I've noticed that the Motley Fool does not talk much about price targets, but I'm hoping you can answer a question I have about them. Sometimes the analysts will give a price target that is much higher than the current price. But the stock is rated as a hold. On the other hand, sometimes a price target is the same or lower and they rated stock is a buy. Can you please help make sense of this for me? I think maybe we should just start with the price target definition, what it is, because I know it for the most part people are going to be following along and no, but I don't want to leave anybody behind your Jason.

Jason Hall: Yes, it's good idea.

Dylan Lewis: So I mean, when we're talking about our price target, we're generally talking about an analyst publishing an opinion on where a stock will be 12 months from now.

Jason Hall: These is sell-side analysts to, you read on Yahoo Finance or one of these other ticker feed sites, are you here on CNBC or something and they say, Wall Street analysts, price targets. They're talking about sell-side analysts. Go ahead.

Dylan Lewis: This is published research that works its way into the financial media. Often this is going out to a client base or something like that, but works its way into articles, and then we have coverage on fool.com that's working its way into this as well and talking about these topics, Jason.

Jason Hall: Great, and a lot of times we're generally kind of hitting on what the analysts are saying to try to put a Foolish take on it. To give them more holistic whole picture of it.

Dylan Lewis: Yeah, and I think where I want to hone in on the question and then the definition here that I think will be telling and why we don't spend a lot of time specifically focusing on this is, for the most part, these targets are 12-month targets and we're looking at specific numbers that are coming from analysts, and most of the folks that follow along with fool we are looking at companies with five 10-year horizon. Just off the bat the timeline that we're looking at these companies is going to be a little bit different than the nature of the analyst price targets.

Jason Hall: It isn't, it's telling if you just look at the accuracy. There are some different websites out there and some data that folks have looked at. In terms of general accuracy, you could flip a coin and you're going to be about as accurate as the directionality or even being within a few percentage points of the price target. But the bottom line is that those price targets aren't really their job. Their job is more about access and providing. They published these things in a very real way to create awareness, and increase access, and a big part of their job, is just providing the research reports themselves to the firm's clients so they can sell more things to their clients. You're not paying for it. Here is what you pay for these.

Dylan Lewis: I think also, if you want to take a critical view of them, they are in some ways promotional tools, and for the firm, and so it is not surprising for an analysts to put a big splashy number out there, especially for a highly followed stock. They're for years seem to be this arms race for who could put out the highest price target on a company like Apple (AAPL -1.22%) and yeah, to your point earlier, there's very little accountability, the follow-on for that, and so what I would say to Heidi and to our listeners members is. There is, I think utility in looking at those reports, what I would tend to focus on more is the why of that price target.

Jason Hall: The worst, not the numbers.

Dylan Lewis: Exactly. The catalysts that they're identifying are the headwinds that they're identifying that lead to that price target because I think the anchor to the number, it's really false precision.

Jason Hall: It really is. The other thing too is that, I mean, we talked about the general lack of accuracy. But the other thing is they do move the market, I think that's one of the reasons people pay attention to them is that there is a little bit of a self-fulfilling prophecy in the short-term. If somebody lowers their price, or they initiate coverage at a price below, the stock tends to move. With that. We're in a day or two. But then over the quarter or over the year, it tends to deviate. That's the thing. You focus like you said Dylan, what are they saying? Does this matchup with my thesis? Does it potentially disproved my thesis about the company and apply it to the total available information that you use when you make a decision about investing in accompany.

Dylan Lewis: Yeah, and they can be super-helpful and identifying blind spots that. We're just broadening your perspective on the business, and I think that's what we'll come back to looking at news items in general or getting opinions from other people in general is it's always better to have more built out, more robust understanding of the companies that you're looking at. One other thing that I think that the price target element highlights some of the ways that, that foolish investing is a little bit different than the way that a lot of the market tends to look at companies is to bring it into our premium ecosystem a little bit. Jason, a lot of places will publish a recommendation or published specific guidance with an entry point or an exit point in mind for that position, and you don't see that with our premium newsletters or with our premium products, that's not the way that we approach investing.

Jason Hall: Yeah, and sometimes I think it gives people a little bit of a false impression that the valuation doesn't matter because it certainly does. But the fact that we don't talk so much about price revaluation, it makes it seem like sometimes particularly on the premium side that we don't follow it on and that's not the case. It's the last thing that we tend to look out we start with, is this a really interesting area, whatever this business status is this a really good business in that are disrupting something else? Are they creating something new? Are they growing the revenues, do you find that revenue number. You think about the things that really lead to success in investing. It starts with revenue growth. The companies that grow their revenues at high rates are far more likely to be market-beating stocks, valuation, throw that out the window. They are far more likely to be market-beating stocks. Then you start to understanding the economics of the business. Do they have really high-gross margins and low fixed costs. They're incremental margins are really high, which means that the valuation that looks insane today, if they continue to grow, all of a sudden evaluation shorter completely changes because their cash flows are really good, and then we look at cash flows. Instead of P ratio or PS ratio and all that stuff. The story tells us, and then at the very end we say, OK, well, what is the valuation today, and can I project that out over 3-5, 10 years to get to a point where I think this stock can grow in this business, get bigger and be a market beating investment over time. You see how the valuation happens at the very end there.

Dylan Lewis: That's backwards for the way that a lot of people invest in. A lot of people look at the market, and I think part of the reason why that philosophy exists at the Fool is we know to some extent if we're off on the valuation part now by call it 10, 20, even 30 percent. But it grows into the innovative business, the compounder that we think it might be. We're willing to accept that because we know the upside is multibagger returns and the price you pay only really matters so much.

Jason Hall: I don't want to pile on value investors, but the bottom line is that the value investing approach, where you starts by looking for cheap valuations. You start there with a bucket of valuations and then you figure out the companies that fit within that valuation that you want to buy, that you think you can generate returns has not done well for the better part of 20 years. Particularly over the past dozen years or so, it has not worked, and I think part of that reason is, we've seen such a dynamic shift in the business world. You think about software, we're going to talk about this in a minute. But how software is driving so many things in so many different ways that the businesses that look like they have great valuations are the ones that have these traditional economics that don't generate these above-average margins, these above average cash flows, and the valuation is just what it is. It leads you into the false trap of looking for value and you're just buying mediocre businesses.

Dylan Lewis: Jason, YouTube me up perfectly for the second question that we are going to hit one later [laughs] this one comes from Martin. Martin asks, you mentioned the article why software is eating the world as part of the tech investor starter kit. What else would you include in the tech investors starter kit? Jason, I think this was a show that you and I did together and this came up on, right?

Jason Hall: Yep it was.

Dylan Lewis: This is the classic Marc Andreessen column that basically Internet lower at this point. In how forward thinking it was and how true it was, and it really speaks to that exact dynamic you were just talking about for Jason, where what we've seen with the software businesses is incredible scale.

Dylan Lewis: Financials that defy a lot of conventional valuation metrics and that forced a lot of people to really reapproach how they look at losses. They're willing to accept margins that they are increasingly more and more attracted to, etc. If you're not someone who's read that yet, highly recommend it. That said, it is not the only good primer, I think, for investing in the space. We can talk about a couple of different sources here. Why don't we kick it off first with just a couple of bucks that make for great primary material.

Jason Moser: Yeah. This is a little bit of a gratuitous self promotion, David and Tom Gardner's book Rule Breakers, Rule Makers. This book is 21 years old, Dylan, I want to say that. But I think at the end of the day, it's not just about tech investing, but it's about high growth. Which in a very real way typically means a lot in tech but it's just a really good book that talks about disruption and it talks about companies going through these different stages of growth. It talks about the investing philosophy that David and Tom Gardner have developed. I think it's just a really informative, helpful tool because if you look at David and Tom's record over the past 25 years, it's self evident. It's a system, it's a process, it's a methodology that absolutely works and I think it's a useful book, even though it is 20 years old at this point, 21 years old, I think it's a really good book to read.

Dylan Lewis: It's fun. There's a great quote about reading a book where it basically allows you to borrow someone's brain for a little while and spend some time there.

Jason Moser: There you go, yeah.

Dylan Lewis: I think that that's going to be the theme of all of the different sources of tech investor's starter kit type material that we cite here. There are some other classic investing books that I'll throw on this list. Innovator's Dilemma, Clayton Christensen being one, Peter Thiel being another just a fantastic tech investor. I think it's hard to argue with Peter Thiel's track record [laughs].

Jason Moser: One of the two or three best tech investors in history.

Dylan Lewis: Yeah. Just someone who has remarkably been in the right place at the right time, so many times that you can't call it luck.

Jason Moser: Right. Exactly. You mentioned The Innovator's Dilemma, I would say any book Clayton Christensen has written, and he has written about a half a dozen books. They talk about innovation and disruption and probably the bigger part of that is changed management and innovation. That's one of the most difficult things for businesses to manage through, and it's one of the reasons that very successful companies eventually fail or struggle or get disrupted is because they run into that innovator's dilemma of figuring out how to change. How to kill off their best success or how to cannibalize their own business. Microsoft, this is a company that struggled with that for a very long time.

Dylan Lewis: Yeah, it's amazing. You can basically chart the period that they resisted innovating themselves or disrupting themselves, with them being a flat company. Once they decided to make that decision and open up some other business segments, off to the race, it's been one of the best mega tech stocks to own of the past eight years.

Jason Moser: Yeah, it's absolutely incredible. Anybody that bought it at the highs in 2000 and managed to hold through all this period, he's still done incredibly well. But anybody that decided to buy it in the early 2000s for that, they call it the lost decade, has done enormously well with this company that our colleague, Tim Beyers, says is the best run tech company in the world.

Dylan Lewis: I think it would be a mistake to not say that you can also, in addition to these specific books and podcasts and things that we're going to be citing here, look at specific companies as great opportunities for learning. I think on four dozen times on the show talked about why Apple is probably one of the best companies you can buy as an investor to learn. I think Microsoft is probably in that bucket too where if you're going to make that first purchase of a company and you're dipping your toe into the market as a new investor, you want to do it with the intent of learning. There is no way to learn better than to learn from the best and to pay tuition, and hopefully have that tuition grow by buying quality businesses rather than have been an expense for you. I have found just in Apple's case, understanding the importance of software and expanding margins, the importance of ecosystem, the importance of a gated community and finding ways for large businesses to continue to grow for it to be a remarkable resource, and following along with conference calls and that kind of stuff in just better understanding what other companies are trying to aspire to do.

Jason Moser: I think the key too, I want to stress this, Dylan, on about your point, it's not buying the stock and then watching the ticker every day to see if it's moved up or moved down. But it's buying the business and thinking about it like a business owner, as if you invested in a local business in your town, where then you get actively involved. It's the same way with Microsoft or how do you get actively involved? You read their AKs. When they announce the press release to talk about some new software they've developed, you read their quarterly earnings filings, you read the transcripts, listen to the calls if you can. Let me say Satya Nadella is not an open book per se, but he is so thoughtful and he talks specifically and also broadly in a way about where the industry is moving and where Microsoft is moving, that you will learn a tremendous amounts about technology and about software companies, just reading the earnings transcripts.

Dylan Lewis: With the earnings transcripts, you have the added benefit of seeing the questions that analysts that follow that company are asking, and the areas that they're focusing on. Sometimes it's because they're trying to punch a number into their model and understand what it translates to. But often it's looking at the major tailwinds for those businesses. I think it's another nice way to borrow someone's brain. The last thing I'll throw out there, Jason, in this zone is if you're specifically interested in the Cloud and really in software, I would highly recommend Jamin Ball's Substack, Clouded Judgment. If there is a prospectus on a software company, you can guarantee he's going to do an overview of it and put the numbers from that company into the broader industry context. I think it's a great resource if you're looking specifically at companies in that zone. Because he does the work on the industry analysis, he has it all aggregated for you and can contextualize it well. But also, he's got a framework for how he looks at companies and breaks it down and uses it every single time. Similar to the analysts asking the questions on a conference call, you can see the categories that he breaks his overviews down into and it's very helpful for identifying the things that you, as an investor, should be paying attention to.

Jason Moser: I've got one too that I'm a big fan of. Ben Thompson, Stratechery, is a great read, then also is a great Twitter follow. Has since a daily email. Go to Stratechery, go to his website and sign up for those daily emails. Because you get really good stories. Really good storyteller, and also some really in-depth explanations of a lot of things that are going on, that are driving these companies and the decisions that they're making. He also interviews a lot of people that he argues with and disagrees with. It is so incredibly helpful. I would put Ben Thompson up there, which have been involved too.

Dylan Lewis: Well, I think that's a pretty good starter kit right there, Jason.

Jason Moser: Yeah, I think so.

Dylan Lewis: [laughs] The final question we'll get to hit today, this one comes from Stephen, and it takes us into the weeds pretty fast. Hey, podcasters. Can we hear about your thoughts on payment for order flow and its impact on retail investors like us. I know payment for order flow shot up into the limelight during the GameStop super short squeeze at the beginning of the year, feel like it's a contentious black box. On one hand, PFOF, payment for order flow, introduces or could introduce a conflict of interest because brokers are rewarded by the market-maker in this when trades are over. On the other hand, they are always submitting trades for best execution. What's more, payment for order flow undoubtedly paved the way for brokerages to cut commissions to zero. I don't want commissions to come back, and I don't think I'm alone in saying that. Basically, this is a topic, Jason, that has gone from being behind the scenes probably for the last couple of years in particular and growing and prominence to something that even the average investor is far more aware of and maybe knows the quick take on. Before we get into our specific thoughts, Stephen's question actually did a decent job framing up some of the elements of this. But I do want to just explore what happens when you make a trade because I think we need to understand those gears turning before we understand some of the next level discussion here.

Jason Moser: Right. We know nothing is free. It's how does this thing that's free to us to trade, how does it actually get paid for?

Dylan Lewis: Right, and it's fascinating, perhaps more than some people want to know, but it's worth exploring a little bit. When you buy or sell a stock in your online brokerage, it seems your broker is making that happen when you hit by yourself. It's happening practically and instantly and as the user interface goes, you don't see what happens after you hit that button. It is very unlikely, not very unlikely, but it is unlikely that that broker is the one who's actually executing that order for you.

Jason Moser: Facilitating it with somebody who is actually, there's a market-maker that's doing it.

Dylan Lewis: Right. Odds are, there is not someone who is submitting the exact same order at the exact same time and is there to be the buyer if you're the seller or be the seller if you're the buyer. They are looking for people that can help facilitate that and add liquidity to the market, and that is where these market-makers come in. These are firms that fulfill orders and really, I mean, that's a huge chunk of what they do. They facilitate transactions, they create a fluid market. They are willing to do this, Jason, because they collect a small spread on what sellers are willing to sell the stock for at any given time and what buyers are willing to pay for it, and it is not a lot of money for that individual spread, but over a large volume of transactions, it can become a lot of money.

Jason Hall: Right.

Jason Hall: That's exactly the thing. You take a very small shaving of millions of trades and you end up with enough money to make it worth doing.

Dylan Lewis: Yeah. That is basically their payment for assuming the risk that there may or may not be someone that they can then move those shares over to. Generally, especially for small retail orders and for highly traded names that have a lot of volume, they're going to able to find it pretty easily and by the end of the day, wipe everything out that they need to. They're happy to do all of this, and it's relatively easy money for them, particularly in the retail zone, because the orders are not market moving orders too often. It's a good business for them. They are happy to pay brokers a portion of that spread. I think the easiest way, Jason, to think about that is it's a rebate that essentially comes back to the brokers for passing that trade along to the market-makers. Aggregated over the course of all of the trades of, of course of days, weeks, months, years, it becomes very big. In 2020, TD Ameritrade, Robinhood, E*Trade, Charles Schwab, collected and estimated 2.5 billion in payment for order flow, a number that tripled from 2019. We saw a huge surge in retail interest and surprisingly, we saw a huge surge in payment for order flow. From Robinhood S1, just to help paint a picture, for the year ended 2020, revenue drive from payment for order flow and transaction rebates represented 75 percent of our total revenues. This shows you where the money is coming from and exactly how big that pie is.

Jason Hall: I think it's interesting too, and I want to hit that again. Robinhood is been made out to be the bad guy here, because if you go back to the AMC GameStop, all of everything that happened earlier this year with the short squeeze, it was right in the middle of it. There have been some documents that have come out that have corroborated. Maybe there were some not customer-friendly things that were happening, but TD Ameritrade, E*Trade, Schwab, Robinhood is not the only broker that's doing this.

Dylan Lewis: It's an industrywide practice. It's part of the game. I think the critics would say, these payments, like a lot of financial incentives, have the potential to work the incentives of the brokerages, temping them to route orders to the market-makers that offer the best rebates, while also satisfying their needs to offer the best price to their customers, because there is some wiggle room in exactly the way that that's defined and maybe not offering buyers and sellers the best prices for their securities that they could possibly get on the market.

Jason Hall: Right. But again, the idea here is that in a perfect environment where there's no conflicts of interest, we're talking about fractions of a percentage each way for the buyer and the seller, that the volume is where they make the money. It's not like as a seller, you're losing five percent or as a buyer you are paying five percent more. We're talking fractions of a percent.

Dylan Lewis: Yeah. I'll add, one further criticism is that, by having the window into the trades, organizations could theoretically front-run retail investors and pocket very easy money.

Jason Hall: Right. The big thing here is it just a reminder, I think to me, obviously with pay for order-flow, when there's a disalignment of incentives, when the organizations that's paying for the order-flow also has a large financial interests in some of the companies that might be having high volumes, that could be detrimental to whatever their interest is, whether it's long or short, you have a conflict of interest. That's when things go sideways, and all of a sudden it's not a great deal for the retail investor and could actually be harmful. If they decide, "Hey, we're not going to take this order-flow right now," all of a sudden, the liquidity that they were providing goes away.

Dylan Lewis: Right. Liquidity is important for the market. It's important for buyers and sellers. We need it in order to have a thriving market. I do want to offer the other side of this, the pro argument, and I'm going to quote this from the a16z blog from Andreessen Horowitz, when things go according to plan, market-makers receive more and more orders and can often trade inside the published bid ask spread, actually improving the price you received compared to the best quoted price on any exchange, filling your market by order for Facebook at 26. He gets into specific numbers here. But the point is basically, there are other fees associated with working specifically with the exchange and also by the volume that they operate on, they may be able to offer better price dynamics to customers than the exchanges can. I don't want that to get lost here. But I think to bring it back out of the guts of this, Jason, the unfortunate reality is, you have to pay for services somehow. It's whether it's happening explicitly or where it's potentially happening as it's baked in way that you don't quite see.

Jason Hall: Right. These companies have a right to make a profit, and if this is the model that they've chosen to do, it creates an opportunity for us as retail investors to reduce our direct expenses, that's fantastic. But just like with any other investment process, this is one that saves you investing fees. The companies that you invest in, it's important to understand their financial incentives. We think about everything that's going on with Facebook right now, and the bottom line is that the users are the products. The customers are the advertisers, so there's a disalignment of incentives. That's really at the core of everything that Facebook is being accused of right now. If you understand those sorts of things about your businesses, you don't get side-swiped when things don't go according to how you expected. I think one of the most important things to me that this is a takeaway, is understand alignment of incentives, whether it's the companies that you invest through, that you invest with, that you work with, that you work for, and you're less likely to get caught unawares.

Dylan Lewis: Yeah. I think to bring it around to how it impacts the retail investor, if you're paying seven dollars portrayed as a classic commission, the incremental costs that may be passed onto you through any misalignment with payment for order-flow, you're probably still coming out positive on that if you're a small-time investor. If you're working in a lot of shares, the numbers might change a little bit, but you also might be someone who would've been trading commission-free anyways. It's hard to triangulate what the exact impact is on the average person here. I think broadly, we're in a period where it is about as good as it's ever been for being an individual investor and participating in the financial system.

Jason Hall: 100%. Even this flawed system that has things about it that can be flawed, I think you're right, Dylan. It's probably about as optimal as it gets. The more transparent it becomes, the less likelihood of those disalignment of incentives becoming a problem for investors.

Dylan Lewis: I like that. I think takeaways from this episode are borrow people's brands, focus on the incentives, Jason.

Jason Hall: We can't say much more than that, Dylan.

Dylan Lewis: I'm always happy to borrow your brain. Thank you for joining me on today's show.

Jason Hall: That's good. Sometimes it gets dark and weird in there. It's a Friday though, so we kept it good. Dylan, I love doing this with you. It's a lot of fun.

Dylan Lewis: Nice to keep it light. Listeners, that's going to do it for this episode of Industry Focus. If you have any questions or you want to reach out and say, hey, shoot us an email, [email protected], or tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or wherever you get your podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned so don't buy or sell anything based solely on what you hear. Thanks, Tim Sparks for [inaudible 00:29:20] and thank you for listening. Till next time, Fool On!