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Google reported its quarterly earnings last week, which means that the 29 brokerage analysts who follow the stock have just revised their financial projections and adjusted their price targets. As ever, Google's newly revised value is in the eye of the beholder—the most pessimistic of the analysts now believes that Google's stock (currently at around $470) is worth $415; the most optimistic, $650. The analyst at Bank of America, meanwhile, believes it is worth exactly $601.
Who's right? Which target should you believe?
None of them. No analyst, no matter how talented, knows what Google—or, for that matter, any stock—is really worth.
To understand why this is so, you need to understand that price targets are not precise scientific facts but extremely subjective estimates. To calculate price targets, analysts must make numerous assumptions, each of which has a major impact on a stock's estimated value. For a variety of reasons, Wall Street and the investment media love pinpoint price targets—they are simple, precise, easy to understand, legally defensible, and reassuring—but the truth is that the range of reasonable valuations for a stock like Google is wide enough to fly a 747 through.
To appreciate this, it helps to understand some basic valuation theory. The value of a stock, theoretically, is the "present value of future cash flows." Loosely translated, this is what all the cash a company will pay to shareholders from now until the end of time would be worth if it were delivered in one lump sum today.
To determine the "present value of future cash flows," an analyst needs to know the following:
1) the amount and timing of the future cash flows
2) an appropriate "discount rate" with which to determine what the cash flows are worth today. (Thanks to inflation, risk, and opportunity cost, a dollar expected to be received in a year is worth less than a dollar delivered today, and a dollar expected in 10, 20, or 100 years is worth a lot less than a dollar today.)
3) A "terminal multiple" with which to value the cash flows that will be received after an explicit forecast period (usually five or 10 years).