Where does the investment value of target prices come from?

Equity analysts’ target price can be decomposed into two components: the earnings forecast and the price-to-earnings (P/E) ratio forecast, with the former containing shortterm earnings news and the latter containing news about long-term earnings growth and discount rates. Using a large database of target prices from 1997 to 2004, we document that both components are important in driving target price revisions and that earnings forecasts are relatively more important for stocks with smaller market caps, higher book-to-market ratios, higher levels of capital expenditures, slower sales growth, and lower past returns. While earnings forecasts are clearly associated with the investment value of target prices, we show that the discount rates implied in P/E ratio forecasts are also valuable. A target-price-based trading strategy produces a significant risk-adjusted profit of above 1% per month even among stocks where target price revisions are mainly driven by revisions in discount rates. This evidence suggests that equity analysts also provide informative forecasts about discount rates.