Putting A Price Target On A Stock
There’s one simple rule when it comes to investing: buy low and sell high. It’s a simple enough philosophy in theory, but much harder to implement in practice. In order to actually make a profit, you need to purchase a stock at a cheaper price than when you sell it. The problem lies in knowing what price a stock should be trading at and when you should buy it – and conversely, when you should sell it.
Knowing what price a stock should be valued at is something Wall Street analysts excel at uncovering. Through rigorous research they are able to estimate data in advance and place target prices on stocks so investors know where a stock will be trading at in the future. It may seem like pseudo-science to guess what the future will bring, but the actual methods for predicting where a stock will be trading aren’t quite as complex as you might think. With a little due diligence, you’ll be able to track your own stock picks and make estimates as to where they’ll be trading a year from now or even longer.
The 4 Elements of Setting a Target Price
In order to place a target price on a stock, you’ll want to know four fundamental pieces of data: sales, profit margin, earnings-per-share, and valuation multiple. These four items will allow you to make predictions about where a stock is headed and understand exactly why the stock will be trading at a given price in the future.
You can a company’s sales (revenue) history on its Income Statement. Going back 10 years and comparing its quarterly revenue will give you a pretty good idea of its sales growth rate and allow you to calculate where sales will be in the future.
Estimate Profit Margin
Much like calculating future sales, you can find historical net profit margin information on the Income Statement. To find the net profit margin, you need to know the company’s operating expenses, cost of goods sold (COGS), interest and tax from revenue and dividend’s from preferred shares (be careful not to include dividends from common stock). Once you have that figure, simply divide net profit by revenue to get the total net profit margin.
Once you know the company’s net income, you’re ready to convert it into earnings-per-share (EPS). To calculate it, you need to subtract preferred dividends from net income and then divide by the number of shares outstanding. As with sales and profit margin, you can also get an idea for the company’s long term EPS history as well to get an idea of how fast EPS growth is.
Decide on a Valuation Multiple
Finally, you’ll need to place a valuation multiple on the stock to determine its value. This is done via the price-to-earnings ratio (P/E). You can get an idea of what multiple to use by looking at the company’s 10-year average P/E or base it off of its competitors and industry average. Once you figure out what P/E to use for the stock, all you need to do is multiply it with the estimated EPS and that will give you your stock target price.
Remember that even the best analysis can be proven wrong if a company changes the way it does business, changes how it figures taxes or makes new acquisitions. As a result, you’ll want to keep your target price analysis to 12 months and not try to estimate too far out unless you have an in-depth understanding of how that business operates.
Once you can determine your own target prices though, you’ll be able to make better investment decisions and avoid jumping into stocks that don’t have any room for price appreciation. It’s also a good way to time your trades – once you hit your target price, you know that you can sell it unless new data shows a change in the stocks target price.