The perils of price guides

When is the ‘Sell’ price not the price at which you should sell? When a company’s valuation has increased substantially.

Members love our price guides. And, if truth be told, I’ve come to like them too. While they can encourage anchoring, they also enforce a type of discipline on us analysts. If a stock falls below our ‘Buy’ price – a proxy for the existence of a margin of safety – we’re more likely to upgrade.

That means more Buy recommendations – and we all want those.

But price guides do have their problems – perils even. One is that you might see the ‘Sell’ price as a price target – the price at which we will definitely recommend you sell your stock. Indeed, this is a form of anchoring.

Take Trade Me (ASX: TME), for example. When I took over analytical coverage of the stock last year, it had a Buy price up to $4.00 and a Sell price at $6.00. I generally agreed with the price guide, and left the prices as they were, although I didn’t believe them to be particularly conservative (partly because it took me time to understand how good a business it was).

Buy (and large)

Around the time of my first two articles covering the company – Trade Me’s insurance foray and Trade Me: Result 2015 – the price was a whopping 30% below our Buy price. We said at the time it was a good opportunity, but mis-pricings of this magnitude are rare (and mght actually be an indication we’ve got our valuation wrong). The Sell price seemed a long, long way away and at the time it represented 32 times historical earnings.

With the price up more than 70% since then – and the company’s profit recovery unfolding as we expected – we recently upgraded our Buy price to $5.25 and our Sell price to $7.50.

Member Hugh T asked a reasonable question on publication of this latest review: ‘Is it possible at an earlier stage to give the Sell price more room in price guides on high quality companies like Trade Me?’. He’d seen the $6.00 Sell price as having inadequate upside when he was considering buying around $3.90.

As you might imagine, though, we prefer to be conservative. A Sell price of $7.50 back in 2015 would have represented 40 times historical earnings for a business that wasn’t growing earnings. That certainly wouldn’t have been conservative and, if our valuation did end up being wrong, we would have looked like right ding-dongs. So you can imagine our reluctance to give the Sell price ‘more room’ at such an early stage.

Myer One-fifty

Another member asked a similar question of Myer (ASX: MYR) back when our (Speculative) Buy price was up to $1.00 and our Sell price was $1.50. He didn’t consider that ‘sufficient upside’. But we’ve since lifted Myer’s Sell price to $1.80 as we’ve become more comfortable with the business turnaround. In fact, we can imagine our Sell price moving to $3.00 for Myer eventually – assuming a great deal more goes right, of course.

So, when assessing the price guides, it’s best to see them as follows: the Buy price is the price at which, at any point in time, we think there's enough value (also known as margin of safety) that most members, with typically balanced portfolios, should consider buying some; the Sell price is the price at which, at any point in time, we'd consider that there is no longer any value (aka margin of safety) in a stock. It’s definitely not a price target, or a valuation cap.

Ideally, as a company’s value improves, or as we grow more comfortable with our valuation, the Sell price for high quality companies will be increased – exactly as it has been for Trade Me. Indeed only part of an investor's return will come from dividends, and the rest will come from share price growth – so, depending on the opportunity cost you factor into your valuation on a stock, you would expect it to march upwards over time. If a stock has a dividend yield of 4% and you think is priced to deliver a 10% return then – all things being equal – you'd expect your valuation for the stock (and associated price guides) to rise by 6% a year (so as to generate that 10% return).

All things are rarely equal, though, so our valuations change, and we must be able to move the price guides around. Unfortunately this also works the other way. Sometimes we’ll lower price guides when value deteriorates or we get it wrong. Thankfully this reporting season most price guides have been of the ‘increased’ variety.

Here’s the thing I’ve noticed, though. It’s the quality businesses where values have improved and our price guides have been lifted. Perhaps that isn’t so surprising after all.