This Just In: Upgrades and Downgrades


At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Big news for big caps
Wall Street went long for large caps this week, as analysts played it safe early on in the New Year. In a series of new upgrades, we saw Deutsche Bank up Johnson & Johnson to "buy," Janney Montgomery Scott assign a similar rating to Target , and Goldman Sachs add Citigroup to its "conviction buy" list. Let's take these one at a time, starting with ...

Johnson & Johnson
After several years of "patent expirations, a general slowdown in utilization trends, and challenges with its OTC businesses," Deutsche sees J&J pulling out of its slump in 2013. Citing recent drugs approved and new ones coming on market, Deutsche argues that pharmaceutical sales will rise in the current year. Combined with a "slight improvement in utilization," Deutsche argues that these "improving trends" justify the "premium" at which J&J trades next to its peers.

But does it really? Right now, major pharmaceutical manufacturers such as J&J, Pfizer , and Novartis sell for close to 18 times earnings on average. That already seems a steep price, given that most analysts forecast only 12% annualized earnings growth for the group. And J&J itself costs even more. At a P/E ratio of more than 23, but a projected growth rate of only 6%, the stock both costs more, and is growing less quickly, than its rivals.

Maybe what this stock really deserves is not a "premium" price, but a discount.

Target upgrade misses the mark
At first glance, Friday's second big upgrade appears to have more merit. Janney raised Target to a "buy" rating to close out the week, and with the stock costing only 13.4 times earnings, growing at close to 12%, and paying a respectable 2.4% dividend yield, that almost makes sense.

That is, until you take a closer look. There are two things that keep me from endorsing Janney's buy rating on Target: debt, and cash production. On the debt front, Target carries more than $17 billion more debt than cash on its balance sheet. Factor that into the valuation, and the stock's enterprise value is close to 19 times the amount of earnings it reported over the past year.

Target's also a bit of a free cash flow laggard, generating only about $0.94 worth of real cash profits for every $1 it reported earning over the past year. This gives the stock an enterprise value-to-free cash flow ratio of nearly 20. Given that the stock's expected to grow at only 12% or less annually over the next half-decade, this suggests that Target, too, may be a big-cap dud this year.

Citi trending?
And finally, we come to Citigroup, recipient of the coveted "conviction buy" endorsement from Goldman. In its upgrade Friday, Goldman pointed out that Citi currently costs only 7.6 times its fiscal 2014 projected earnings, versus an average 11 forward P/E for other big banks.

Goldman thinks this discount unjustified, given that the megabank possesses "considerably more levers to protect and grow earnings in a difficult revenue environment." The analyst thinks CIti's cost-cutting efforts will ultimately enable Citi to generate 11% returns on tangible common equity, versus the 4% RoE Citi currently boasts.

Moving from 4% to 11% seems to suggest a near tripling of Citi's profitability. For an apples-to-apples comparison, though, remember that Citi's official book value is about 20% higher than its so-called "tangible book value." So Goldman's really suggesting a bit more than a doubling of profitability in the future -- from 5% to 11% -- rather than a near-triple. But that's still quite an improvement.

It's also a popular opinion ... but that doesn't make it right. Priced at roughly 18 times earnings today, consensus projections have Citi selling for 9 times this year's earnings. This suggests pretty impressive one-year growth. But if you average it out over the longer term, most analysts still see Citi compounding earnings at only 11% per year over a five-year period. And 18 times trailing earnings is an awful lot to pay for 11% growth.

Result: The 45% gain Citi stock notched over the past 52 weeks may be the top for Citi. Further improvements will be a lot harder to come by. If investors are looking for a lower-risk bet, and one offering a better chance of earning a profit, they'd be best advised to look at a stock already scoring low on the P/E meter. For example, JPMorgan Chase , at 9.6 times trailing earnings, could produce 7%-plus growth over the next half-decade. JP also pays a respectable 2.7% dividend yield, versus Citi's meager 0.1% yield. For that matter, Goldman Sachs itself looks downright attractive at a 20% projected growth rate (per S&P Capital IQ), but only a 13 P/E.

In any case, both JP and Goldman itself look like far more compelling ideas than the stock Goldman names as its "conviction buy."

With big finance firms still trading at deep discounts to their historic norms, investors everywhere are wondering if this is the new normal, or whether finance stocks are a screaming buy today. The answer depends on the company, so to help figure out whether Goldman Sachs is a buy today, I invite you to read our premium research report on the company today. Click here now for instant access!

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Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs Group, and Johnson & Johnson. The Motley Fool owns shares of Citigroup Inc , Johnson & Johnson, and JPMorgan Chase & Co.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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