When it comes to evaluating stocks, target prices can be even more useful than an equity analyst’s rating. Strictly defined, a target price is an estimate of a stock's future price, based on earnings forecasts and assumed valuation multiples. This article investigates what people should know about target prices, and contemplates how these reports can lead to wiser investment decisions.
- A target price is an estimate of a stock's future price, based on earnings forecasts and assumed valuation multiples.
- When it comes to evaluating stocks, target prices can be even more useful than an equity analyst’s rating.
- While ratings have limited value, because they are opinion based, thoughtfully constructed target pricing models can legitimately help investors evaluate the potential risk/reward profile of the stock.
Why Target Prices Are Better Than Ratings for Investors
First and foremost, ratings have limited value, because they are opinion based. While one analyst may rate a stock as a “sell”, another may recommend it as a “buy”. More importantly, a rating may not equally apply to every investor, because people have different investment goals and risk tolerance levels, which is why target prices can be so essential to rounding out research.
It should be stated that the quality of a target pricing model is only as strong as the factual analysis behind it. While a shoddy thesis behind a target price can lead investors astray, thoughtfully constructed target pricing models can legitimately help investors evaluate the potential risk/reward profile of the stock.
4 Keys to Target Price
Investors should consider following four factors, in determining the legitimacy of a target price:
Earnings per share (EPS): A keystone element of the target price, this report should contain a detailed earnings forecast model, including a full income statement with a discussion of operating cash flows for the time frame covered by the target price. A quarterly forecast for the next 12 months is useful for tracking the accuracy of the analysis and evaluating 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 readers can evaluate their credibility. Reports that lack detailed earnings models and lists of assumptions, should automatically raise red flags. It is important that the assumptions are reasonable. For example, if a micro-cap company’s sales grew just 1%-2% over the last two years, it would be illogical to project a double digit growth over the following two years, unless there is a significant event, such as a new product rollout, or a patent approval. These game-changers should be incorporated into detailed earnings model so readers can adjust their assumptions accordingly. (Learn more about EPS in: How To Evaluate The Quality of EPS.)
Valuation Multiples Used to Calculate the Target Price: Target prices heavily rely on valuation multiples, such as price/earnings (P/E), price/book (P/B) and price/sales (P/S). Each valuation multiple should appropriately apply to the stock in question. For example, the market places more emphasis on P/E multiples for industrial companies, while placing greater importance of P/B numbers for banks. Furthermore, valuation models should rely on a host of different variables. A model based on just one multiple is like a one-legged stool--unsturdy and unreliable.
Assumptions Used to Justify the Valuation Multiples Used: Whether they are used to support earnings forecasts or valuation targets, assumptions must always be reasonable. This can be determined by comparing assumptions to historical trends, relevant peer groups, and current economic expectations.
If a stock has consistently traded below its peer-group average, but the forecast projects the multiples to be larger than its peers, it’s vital to investigate why this stock is suddenly expected to outperform. While there may be legitimate reasons behind such projections, such as FDA approval of a new drug, only investors with high risk tolerance levels invest in such a story. (For related reading, see: 5 Must-Have Metrics for Value Investors.)
The Bottom Line
Target prices can go a long way in helping investors decide if a stock warrants investment. A good target price considers a set of four factors. Without all of them, investors should dismiss the target price report outright, as it could be a pump-and-dump marketing ploy.
(For further reading, check out The Short And Distort: Stock Manipulation In A Bear Market.)