Placing a Price Target on a Stock
Successful investing requires doing a certain amount of due diligence to avoid making costly mistakes. Pouring over financial statements, analyzing ratios and charts, and reviewing comparable statistics to other similar stocks takes time. But it’s all worthless unless you understand exactly how much a stock is actually worth.
Knowing when to buy a stock and when to sell it is the difference between good investors and great ones. Finding value is meaningless if you don’t know what the number actually is. Before buying, you need to have a number in mind to sell at – whether it’s 10%, 20%, or 50% higher. You need to know how to put a price target on stock.
A stock’s value comes from a number of different metrics working together. A company’s earnings are only part of the equation – the other part is the multiple investors have placed on the stock, commonly known as the price-to-earnings ratio (P/E). A stock trading at $20 per share with earnings of $1 per share would have a P/E of 20.
Earnings change over time, though, generally starting out fast when the company is smaller and younger and then slowing down and becoming more stable once the company reaches a certain size. Making EPS forecasts is important for placing a price target on a stock, but one mistake investors tend to make in this process is assuming an unrealistic growth rate. A small cap company that has been growing at an average of 25% annually might be impressive, but investors assuming this as a long term growth rate will likely be disappointed and over-estimate the future value of the stock.
New developments can change EPS assumptions, as well. A new product, acquisition, or technology can affect EPS guidelines, meaning that investors will likely need to change their price target the longer they hold a stock.
Finally, the market will place a valuation multiple on stock that needs to be taken into account when estimating the future price of a stock. Depending on the industry, it could be the price-to-earnings, price-to-sales, or price-to-book ratio. Some industries require looking at other metrics, such as mining stocks, which base their value off of the value of their total reserves.
While getting an accurate estimate of a stock’s true value is critical, there are many factors that can affect price other than earnings changes. The valuation multiple is arguably the most unstable part of price determination because it’s based off nothing more than assumptions and comparisons to similar companies. Investors can change assumptions based off various macro and micro-economic reasons, making it a difficult ratio to justify. Comparing it to past historical averages on the same company helps, but comparing it to the multiple placed on companies in a similar industry is the best way to find undervalued stocks, while simultaneously putting a price target on a stock.