As we head into earnings, if your strategy is buying into analyst estimates—this tip and reminder: Estimates are based on assumptions that generally are used to justify stock price targets.
There’s no standardization of what goes into assumptions, which means there is no guarantee the assumptions won’t be flawed.
Take, for example, JP Morgan’s July 1 report on Apple , which had a $390 price target by December 2011. (Mind you: This has less to do with Apple, more to do with assumptions.)
That’s just one of any number of ways to value a company. And it assumes that the price/earnings multiple will expand, and not just by a small amount: From around 15.7-times today to—worst case, according to the analyst—20-times forward earnings. (And this is in the world of tech, where the average P/E is closer to around 10.)
Never mind that the analyst’s target is nearly a year-and-a-half away—enough time for anything to get in the way of the assumptions; or that P/Es tend to contract over time—not expand; or that the law of large numbers will kick in, especially after Apple’s spectacular performance.
More importantly: Anything can happen between here and there, including a disappointment—yes, even with a company like Apple.
And, as great growth companies like Wal-Mart (dead money for the better part of 10 years), Coca-Cola , Google and others have shown over time, if and when growth disappoints, P/Es shrink.
Apple, in due course, will be no exception.
P.S.: Based on Apple’s short-interest, which is at the lowest rung of any S&P 500 or Russell 1,000 company, most investors don’t expect that to happen any time soon.
Put another way, virtually nobody is on the other side of the Apple trade.
"The Strategy Session," hosted by David Faber and Gary Kaminsky, airs weekdays at Noon ET on CNBC.