• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

Suresh Krishnamurthy

WHAT do analysts of research outfits do when price targets fixed by them earlier are about to be breached? If you thought they would be prepared to advocate a sell, you would be wrong. In a bull run, they only revise them higher. At least, that is what UBS has done for Infosys Technologies, as has Morgan Stanley for HDFC and Merrill Lynch for SBI.

For Infosys, the price target was revised from Rs 4,500 to Rs 5,200. For HDFC, the revision was from Rs 502 to Rs 563, and for SBI, from Rs 500 to Rs 650.

These revisions were made in September 2003. So, if the prices of many other stocks are now closer to their target price, it may not matter much because the target prices may be revised upwards and can be justified with higher expected earnings growth.

In addition, even without any mid-quarter revision, price targets are subject to revisions after the quarterly earnings announcement. Price targets, in effect, have a short life. They keep changing.

Targets matter: Still, price targets do matter, as in the present case. It is because of the earnings growth rates based on which these price targets have been fixed. In the 70 stocks considered for our analysis, the median expected growth in per share earnings for 2003-04 was pegged at a bullish 20 per cent. Importantly, in almost all cases, strong growth is expected to continue in the following couple of years.

For example, Morgan Stanley expects HDFC to record earnings growth of 23 per cent in the year ended March 2005. Similarly, UBS expects Infosys to record earnings growth of about 20 per cent in the financial years 2004-05 and 2005-06.

Except in the case of the banking sector, there is little reason to disagree. It is difficult to suggest that earnings growth could be even higher than what that estimated by the analysts. In banking sector stocks, barring SBI, you might think that research outfits are pessimistic. In the other sectors, however, the analyst forecasts themselves are optimistic.

Analysts are often accused of wearing rose-tinted glasses. So, further upward revisions to price targets may be difficult to justify. In this backdrop, that stock prices are now close to targets based on such optimistic estimates does matter. They suggest that a significant rise in prices in large-cap stocks may be unjustified.

Can generate returns: Still, if large-cap stocks are now fully valued, it does not mean they will not generate returns or that future returns will be negative. A fully valued large-cap stock is expected to deliver returns in line with the risk involved in the stock.

For instance, Infosys. The target price of Rs 5,200 was arrived at using a weighted average cost of capital of about 12.5 per cent. This means that if the stock price reaches Rs 5,200 now, and earnings growth expectations fully materialise, the stock would still record average annual returns of about 12.5 per cent.

In the case of most large-cap stocks, the cost of capital used to calculate the target price would be 12-13 per cent. So, if you invest in these stocks at their fully-valued price and the earnings growth expectations materialise, you would get returns of about 12 per cent. That is still a decent return given that long-term debt is now yielding 5 per cent.

Even so, savvy investors will not buy stocks that are fully valued. They would want to buy stocks that are less than fully valued. This is not to maximise returns but to ensure that adverse developments in future do not reduce returns sharply. The higher the difference between the target and market prices, the higher is the margin of safety. In this context, investors should be cautious about investing in large-cap stocks.

Only large-cap stocks whose earnings growth targets are not subject to volatility and whose earnings growth expectations are reasonable might qualify for investment. Unfortunately, there may not be many such stocks available. The few that may qualify include HDFC, Grasim, SBI and Asian Paints.

Article E-Mail :: Comment :: Syndication

Stories in this Section
Large-caps: From a bang to a whimper

Copyright © 2003, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line