Target Prices: The Key to Sound Investing - Investopedia

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 ... FundamentalAnalysis ToolsforFundamentalAnalysis FundamentalAnalysis ToolsforFundamentalAnalysis Sectors&IndustriesAnalysis Whenitcomestoevaluatingstocks,targetpricescanbeevenmoreusefulthantheratingsofequityanalysts.Strictlydefined,atargetpriceisanestimateofastock'sfutureprice,basedonearningsforecastsandassumedvaluationmultiples. Thisarticleinvestigateswhatpeopleshouldknowabouttargetprices,andhowthesereportscanleadtowiserinvestmentdecisions. KeyTakeaways Atargetpriceisanestimateofthefuturepriceofastock.Targetpricesarebasedonearningsforecastsandassumedvaluationmultiples.Targetpricescanbeusedtoevaluatestocksandmaybeevenmoreusefulthananequityanalyst’srating.Whileopinion-basedratingshavelimitedvalue,targetpricescanhelpinvestorsevaluatethepotentialrisk/rewardprofileofthestock.  WhyTargetPricesAreBetterThanRatingsforInvestors Firstandforemost,ratingshavelimitedvalue,becausetheyareopinionbased.Whileoneanalystmayrateastockasa“sell,”anothermayrecommenditasa“buy.”Moreimportantly,aratingmaynotequallyapplytoeveryinvestor,becausepeoplehavedifferentinvestmentgoalsandrisktolerancelevels,whichiswhytargetpricescanbesoessentialtoroundingoutresearch. Itshouldbestatedthatthequalityofatargetpricingmodelisonlyasstrongasthefactualanalysisbehindit.Whileashoddythesisbehindatargetpricecanleadinvestorsastray,thoughtfullyconstructedtargetpricingmodelscanlegitimatelyhelpinvestorsevaluatethepotentialrisk/rewardprofileofthestock. 4KeystoTargetPrice Investorsshouldconsiderthefollowingfourfactorsindeterminingthelegitimacyofatargetprice: Earningspershare(EPS):Akeystoneelementofthetargetprice,thisreportshouldcontainadetailedearningsforecastmodel,includingafullincomestatementwithadiscussionofoperatingcashflowsforthetimeframecoveredbythetargetprice.Aquarterlyforecastforthenext12monthsisusefulfortrackingtheaccuracyoftheanalysis and evaluatingwhetherornotthecompanyisperformingasanticipated. EPSForecastAssumptions:Thereportshouldalsodiscusstheassumptionsusedtomaketheforecast,soreaderscanevaluatetheircredibility.Reportsthatlackdetailedearningsmodelsandlistsofassumptionsshouldautomaticallyraiseredflags.Itisimportantthattheassumptionsarereasonable.Forexample,ifamicro-capcompany’ssalesgrewjust1%-2%overthelasttwoyears,itwouldbeillogicaltoprojectadouble-digitgrowthoverthefollowingtwoyears,unlessthereisasignificantevent,suchasanewproductrolloutorpatentapproval.Thesegame-changersshouldbeincorporatedintodetailedearningsmodelsoreaderscanadjusttheirassumptionsaccordingly. ValuationMultiplesUsedtoCalculatetheTargetPrice:Targetpricesheavilyrelyonvaluationmultiples,suchasprice/earnings(P/E),price/book(P/B),andprice/sales(P/S).Eachvaluationmultipleshouldappropriatelyapplytothestockinquestion.Forexample,themarketplacesmoreemphasisonP/Emultiplesforindustrialcompanies,whileplacinggreaterimportanceofP/Bnumbersforbanks.Furthermore,valuationmodelsshouldrelyonahostofdifferentvariables.Amodelbasedonjustonemultipleislikeaone-leggedstool—notsturdyorreliable. AssumptionsUsedtoJustifytheValuationMultiplesUsed:Whethertheyareusedtosupportearningsforecastsorvaluationtargets,assumptionsmustalwaysbereasonable.Thiscanbedeterminedbycomparingassumptionstohistoricaltrends,relevantpeergroups,andcurrenteconomicexpectations. Ifastockhasconsistentlytradedbelowitspeer-groupaverage,buttheforecastprojectsthemultiplestobelargerthanitspeers,it’svitaltoinvestigatewhythisstockissuddenlyexpectedtooutperform.Whiletheremaybelegitimatereasonsbehindsuchprojections,suchasFDAapprovalofanewdrug,onlyinvestorswithhigh-risktolerancelevelsinvestinsuchastory. TheBottomLine Targetpricescangoalongwayinhelpinginvestorsdecideifastockwarrantsaninvestment.Agoodtargetpriceconsidersasetoffourfactors.Withoutallofthem,investorsshoulddismissthetargetpricereportoutright,asitcouldbeapump-and-dumpmarketingploy. CompareAccounts AdvertiserDisclosure × TheoffersthatappearinthistablearefrompartnershipsfromwhichInvestopediareceivescompensation.Thiscompensationmayimpacthowandwherelistingsappear.Investopediadoesnotincludealloffersavailableinthemarketplace. 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Apricetargetisananalyst'sprojectionofasecurity'sfutureprice,oneatwhichananalystbelievesastockisfairlyvalued. more Value Valueisthemonetary,material,orassessedworthofanasset,good,orservice.Discovermoreabouttheterm"value"here. more WhatIsFundamentalAnalysis? Fundamentalanalysisisamethodofmeasuringastock'sintrinsicvalue.Analystswhofollowthismethodseekoutcompaniespricedbelowtheirrealworth. more