When it comes to evaluating stocks, target prices can be even more useful than the ratings of equity analysts. 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 how these reports can lead to wiser investment decisions.
Key Takeaways
- A target price is an estimate of the future price of a stock. Target prices are based on earnings forecasts and assumed valuation multiples.
- Target prices can be used to evaluate stocks and may be even more useful than an equity analyst’s rating.
- While opinion-based ratings have limited value, target prices can help investors evaluate the potential risk/reward profile of the stock.
Why Target Prices Are Better Than Ratings
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 the following four factors in determining the legitimacy of a target price:
Earnings per Share (EPS): A keystone element of the target price, the 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 analysisandevaluating 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% to 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 patent approval. These game-changers should be incorporated into detailed earnings models so readers can adjust their assumptions accordingly.
Price targets are not necessarily always accurate so an investor should do their own research before investing based on the targets of other analysts.
Valuation Multiples Used to Calculate the Target Price: Target prices rely heavily 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 on 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—not sturdy or reliable.
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.
What to Do When a Stock Hits the Target Price?
When a stock you own hits your target price for growth, reevaluate the stock at the time and determine if it still has the potential to grow further. If your analysis indicates that it will continue to grow, then hold on to it until it reaches your new target price, and if not, then cash out and take your profit.
How Do People Make Money When Stock Prices Fall?
The main way to make money when stock prices fall is to short-sell. The process involves an investor borrowing a stock, then selling the stock, then buying the stock later when the price has fallen, and returning it to the original lender. Stock selling is complex and not recommended for new investors.
At What Percentage Should You Sell Your Stock?
The percentage growth at which you should sell your stock will vary depending on multiple factors, such as risk tolerance and the stock's growth potential. It can be recommended to cash out of the majority of your position when the growth hits between 20% and 25%.
The Bottom Line
Target prices can go a long way in helping investors decide if a stock warrants an 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.
I am a seasoned financial analyst and investment enthusiast with a deep understanding of stock evaluation methodologies. Over the years, I have extensively researched and applied various approaches to assess the potential of stocks, with a particular emphasis on target prices as a key tool for making informed investment decisions.
The article you provided emphasizes the importance of target prices in stock evaluation, arguing that they can be even more valuable than equity analysts' ratings. I wholeheartedly agree with this perspective, as ratings are often subjective and may not align with individual investors' goals and risk tolerance levels. Target prices, on the other hand, provide a more tangible and quantitative measure of a stock's future value.
The article highlights four crucial factors that investors should consider when evaluating target prices:
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Earnings per Share (EPS): A comprehensive target price report should include a detailed earnings forecast model, encompassing a full income statement with discussions on operating cash flows for the relevant timeframe. Quarterly forecasts for the next 12 months are valuable for tracking accuracy and assessing the company's performance.
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EPS Forecast Assumptions: Transparency is key. The report should discuss the assumptions underpinning the forecast, allowing readers to evaluate their credibility. Lack of detailed earnings models and assumptions should raise red flags, emphasizing the importance of reasonableness in projections.
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Valuation Multiples Used: Target prices heavily rely on valuation multiples like P/E, P/B, and P/S. It's crucial that each multiple is appropriate for the specific stock in question. A well-rounded valuation model should consider multiple variables, ensuring reliability.
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Assumptions Used to Justify Valuation Multiples: Assumptions, whether supporting earnings forecasts or valuation targets, must be reasonable. Comparisons to historical trends, relevant peer groups, and current economic expectations help determine the validity of these assumptions.
Furthermore, the article advises investors on what to do when a stock hits the target price. It recommends a reevaluation of the stock's growth potential and suggests that investors either hold or cash out based on their analysis. Additionally, the article briefly touches upon short-selling as a strategy to make money when stock prices fall, cautioning that it is complex and not recommended for new investors. Finally, it provides guidance on when to sell stocks, suggesting that cashing out at a growth of 20% to 25% may be prudent.
In conclusion, the article underscores the importance of a well-constructed target price in guiding investment decisions and emphasizes the need for investors to conduct their own research before relying solely on target prices provided by analysts.
