Wall Street’s sell-side technology analysts are pouring gas on the technology stock bonfire, but it’s going to be the rest of us who get burned.

In recent months, these analysts haven’t met a valuation they don’t like. Instead, they are engaged in a game of cat and mouse with the stock market and each other: when market fervor for a given tech stock bumps its price within range of an analyst’s declared target, the analyst simply moves their target price higher; other analysts covering the same stock quickly follow suit. The market, rife with v-shaped confirmation bias and hungry for news, considers this to be a positive sign and bids the stock up to the new price target – and the cycle repeats itself. This phenomenon has been at play with Zoom (NASDAQ:ZM), DocuSign (NASDAQ:DOCU), and myriad other technology companies during the market’s recent bull run.

Shopify (NYSE:SHOP), an e-commerce software company, is yet another example. On Thursday, RBC analyst Mark Mahaney raised his price target for Shopify from $825 to $1,000. The stock, which was trading at around $820 on Wednesday afternoon, was trading above $900 as of Monday.

At the time of writing, Shopify was valued at more than 53 times Trailing Twelve Months’ revenue of $1.7 billion. At a market cap of $108 billion at the time of writing, it is more valuable than Lockheed Martin (NYSE:LMT), GlaxoSmithKline (NYSE:GSK), Honeywell (NYSE:HON), Softbank (OTCPK:SFTBF), and tellingly, The Royal Bank of Canada (NYSE:RY), which is Mahaney’s employer and Canada’s largest bank. At $1,000 per share, Shopify would be worth almost $120 billion, or roughly 9% of the value of Amazon (NASDAQ:AMZN) – with 0.6% of its revenue.

Mahaney thinks Shopify can generate $25 billion in sales and a 20% margin by 2028. If he can see eight years in the future, one has to wonder whether being a sell-side analyst is truly his calling.

How To Consistency Beat the Market With Over a 90% Success Rate

Whether the market is up, down, or sideways, the Option Strategies Insider membership gives traders the power to consistently beat any market. Spend less than one hour a week and do the same.

Just click the link below to see our full presentation on exactly how we do it.

CLICK HERE TO JOIN OUR FREE WEBINAR

A more probable scenario is that Mahaney is using the same valuation air math that is ubiquitous among his technology analyst piers, and in Silicon Valley in general. In the most simple terms, this math involves determining the size of a company’s Total Addressable Market (“TAM”), and then projecting the share of the TAM the company will realize in in the future.

The issue with “projections” like these is that they are fundamentally finger-in-the-air guesses, but are not viewed as such by the stock market. Analyst upgrades move stock prices and have serious (i.e. financial) implications for the investing public. In contrast, if a sell-side analyst is wrong in their prediction, their greatest downside is reputational risk. This risk is almost always mitigated by the fact that the analysts covering a given company tend to mirror each other’s price targets: it’s better to be wrong if everyone is wrong. To put it another way, when there are no financial consequences, the risk of being an outlier who is wrong is greater than the potential reward from being a thought leader who is right.

The market seemingly forgets that analysts are employed by profit-seeking institutions that have different interests from those of the investing public. Their primary function is to provide in-depth research, financial modeling services, and management access to hedge funds and other buy-side investors – free of charge – to incentivize them to use the trading services of the banks that employ those analysts.

The ability to access share price-obsessed management teams, perhaps the most valuable function of a sell-side analyst, can disappear quickly if a management team doesn’t like the tone of an analyst’s coverage. Much has been written about the dearth of “sell” or “underperform” ratings among all sell-side analysts, especially at the height of asset bubbles. Listen to the latest quarterly earnings calls of Zoom, DocuSign, or any other “hot” technology company, for example, and one will hear a lot of congratulating and very little challenging.

The price targets declared by sell-side analysts, especially when plucked from thin air using a TAM calculation, serve no purpose and cause many headaches: they are distracting for company management, who should be worrying about their businesses and not their stock price; they motivate individuals to buy stocks without doing proper research, often at inflated valuations (even if they are willing, the underlying research is not easily accessible to the investing public); they cause large and unpredictable price swings for existing shareholders or short sellers.

Sell side research departments, and the analysts that run them, provide a valuable service to buy-side investors who are important trading clients. But the only people who actually believe, or invest according to, the price targets generated by these research departments are precisely those who shouldn’t.

In my opinion, research departments should stop publishing price targets altogether. However, as that seems unlikely to happen any time soon, analysts should not be allowed to change their price target on a company’s stock simply because its price is going up (or down), when the predominant driving force behind that price movement is clearly irrational hype (or negativity).

If analysts are to continue to have such an outsized influence on stock prices, they should be arbiters of exuberance, not manufacturers of it.

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.