Because they provide additional information that an investor can use to determine if a stock is right for him or her, target prices are better than ratings. This article will discuss what investors need to know about target prices and why they are better than ratings.

Why Target Prices Are Better for Investors
Because ratings are generic comments that do not apply to every investor, investors can make better investment decisions by focusing instead on target prices. Ratings are good sound bites that convey quickly an analyst's point of view, but this is also their fatal flaw. What may be a 'buy' from the analyst's point of view may be a 'sell' to you. Your investment goals and risk tolerance are not the same as the person who wrote the research report. Target prices provide the additional information needed to make good investment decisions. (For a more detailed discussion on ratings see the article, Stock Ratings: the Good, the Bad and the Ugly.)

How to Identify Good Target Prices
Target prices are like research reports: there are good ones and bad ones. The bad ones, which are used to deceive investors, are short on factual analysis and long on deceptive assumptions. The good ones provide information that helps investors evaluate the potential risk/reward profile of the stock.

In order to understand the difference between good and bad target prices, we need to define what target prices are and how they should be calculated. A target price is an estimate of a stock's future price based upon an earnings forecast and assumed valuation multiples. A good research report will present its case for a target price by presenting detailed information. A bad research report is not really a report but a deceptive marketing tool that lacks details but contains plenty of overstatements.

4 Keys to Target Price
Investors need to evaluate the following four key aspect for determining the legitimacy of a target price: the earnings per share (EPS) forecast, the assumptions underlying the EPS forecast, the valuation multiples used and the rationale for using those valuation multiples. Here is how investors can judge these factors.(To read further on earnings, see Can Earnings Guidance Accurately Predict The Future? and A Case Study: Earnings Manipulation And The Role Of The Media.)

  1. EPS Forecast
    This is the foundation of the target price, and the report should contain a detailed earnings forecast model (full income statement with a discussion of operating cash flows) for the time frame covered by the target price (preferably two years). A quarterly forecast for the next 12 months is useful for tracking the accuracy of the analyst and for keeping an eye on whether or not the company is performing as anticipated.
  2. EPS Forecast Assumptions
    The report should also discuss the assumptions used to make the forecast so that the reader can evaluate their reasonableness. A report's lack of both a detailed earnings model and list of assumptions should be a warning sign to investors.

    It is important that the assumptions be reasonable. For example, in the current economic environment it is highly unlikely that a micro-cap company whose sales have grown at a 1-2% pace during the last two years will be able to accelerate sales growth to a double digit pace in the coming two years. A good research report will provide the reasons why the analyst expects a big jump in sales growth (for instance, the company may have acquired a new product or patent) and a detailed earnings model so that the reader can adjust the assumptions (e.g. reduce sales growth expectations) to calculate the impact on EPS and valuations. (Learn more about EPS in How To Evaluate The Quality of EPS.)

  3. Valuation Multiples Used to Calculate the Target Price
    The next building blocks of target prices are valuation multiples, such as price/earnings (P/E), price/book (P/B) and price/sales (P/S). You need to make sure that the type of valuation multiples used are applicable to the stock you are researching. For example, the market places more emphasis on P/E multiples for industrial companies and a P/B multiple for banks.

    In addition to using the right multiples, the valuation model should be based on more than just one variable. A valuation model based on one multiple is like a one-legged stool: not very sturdy or reliable. While the market may place more emphasis on one multiple over another, a good model consists of at least three variables. Three good multiples for industrial companies are P/E, P/B and P/S. Bank prices, on the other hand, are typically based on P/B and to a lesser extent on P/E and price/total income (where total income is defined as net interest income and non-interest income).

  4. Assumptions Used to Justify the Valuation Multiples Used
    Assumptions, whether they are used to support an earnings forecast or valuation target, need to be reasonable. This can be determined by looking at the assumptions and comparing them to historical trends, a relevant peer group (i.e. companies, possibly competitors, that are in the same business) and current economic expectations. Don't worry - this is not as hard as it sounds.

In order to make a good case for a target price, the analyst should include a discussion of the historic trends and an analysis of these trends through a comparison to a relevant peer group. If a stock has consistently traded below its peer-group average (has been at a discount) and the forecast expects the multiples to be larger than the peers (to be at a premium), you need to evaluate the reasons why the market is expected suddenly to discover the stock.

While there are occasions when valuations pop (such as when a company gets an FDA approval to market a drug), they are high risk/reward situations and only investors with that type of risk tolerance should accept those assumptions and invest in this type of situation. There are situations, however, where a stock is legitimately undervalued because the market is not aware of its fundamentals - the company is literally waiting to be discovered. This is a lower risk situation, but it may take a long time before the market adjusts the stock's valuation.

The Bottom Line
Investors will make better decisions if they focus on target prices, which convey more information for evaluating the potential risk/reward profile of a stock. A good target price is based upon a reasonable set of four factors that provide the reader with information to determine the accuracy of the target price. The absence of any of these four factors should be a red flag that the so-called report could really be a pump and dump marketing ploy.

For further reading, check out The Short And Distort: Stock Manipulation In A Bear Market, Finding Undiscovered Stocks and Wham Bam Micro-Cap Scam.

Related Articles
  1. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  2. Markets

    Operating Cash Flow: Better Than Net Income?

    Differences between accrual accounting and cash flows show why net income is easier to manipulate.
  3. Investing Basics

    How To Efficiently Read An Annual Report

    Annual reports are clearly prepared without any intent to deceive or mislead investors. Still, investors should read them with a dose of skepticism.
  4. Investing Basics

    Explaining Financial Statement Analysis

    Financial statement analysis is the process of reviewing a company’s statements to gain an understanding of its financial health.
  5. Investing Basics

    How Financial Statements Are Manipulated

    Financial statement manipulation is an ongoing problem, and investors who buy stocks or bonds should be aware of its signs and implications.
  6. Investing Basics

    How To Decode A Company’s Earnings Reports

    Earnings reports tell investors how a publicly-traded company is performing, but aren’t always easy to decipher.
  7. Economics

    Detecting Financial Statement Fraud

    Fraudulent financial statements account for about 10% of the white-collar crime incidents reported each year.
  8. Economics

    How to Calculate Average Inventory

    Average inventory is the median value of an inventory at a specific time period.
  9. Investing Basics

    Explaining Defeasance

    Defeasance refers to a provision that enables a bond or a loan to be voided once the borrower sets aside enough cash or securities to service its debt.
  10. Economics

    Explaining Appreciation

    Appreciation refers to an increase over time in the value of an investment or asset.
  1. How can working capital affect a company's finances?

    Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>
  2. What are working capital costs?

    Working capital costs (WCC) refer to the costs of maintaining daily operations at an organization. These costs take into ... Read Full Answer >>
  3. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  4. Who actually declares a dividend?

    It is a company's board of directors who actually declares a dividend. The declaration date is the first of four important ... Read Full Answer >>
  5. How do dividends affect the balance sheet?

    Dividends paid in cash affect a company's balance sheet by decreasing the company's cash account on the asset side and decreasing ... Read Full Answer >>
  6. Are dividends considered an expense?

    Cash or stock dividends distributed to shareholders are not considered an expense on a company's income statement. Stock ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center