Because they provide additional information 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.

Why Target Prices Are Better Than Ratings 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 quickly convey 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 report. Target prices provide the additional information needed to make good investment decisions. (For a more information, see: 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.

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. 

4 Keys to Target Price

Investors need to evaluate the following four key aspects to determine 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.

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 analysis and whether or not the company is performing as anticipated.

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 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.)

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 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 number 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).

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 to suddenly discover the stock. (For related reading, see: 5 Must-Have Metrics for Value Investors.)

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 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.