to Set Stock Target Prices
Stock research and analysis
Setting target prices,
is something that professional money managers almost always do, but individual investors
almost never do. This article describes a process that you can easily implement to estimate
In my last
column, I described how value-style managers, investors who seek out
stocks that have been depressed by short-term bad news, use a stock’s
historical valuation ratios to time their buying and selling.
The next step,
setting a target price, is essential to all analysis strategies, but a
step that few individual investors put into practice.
Why is setting
a target price important? Consider an example. Say that you’re analyzing
two stocks; both in similar businesses, and both are currently trading for
$30 per share.
Now assume that
after analyzing relevant factors, you determine that if all goes as you
predict, two years from now Stock A will be trading between $35 and $40,
while Stock B will trading in the $60 to $70 range.
could be wrong, of course, or events may not go as expected, but given
that information, most would agree that Stock B presents the better
varied strategies for determining target prices. The approach that I’m
about to describe incorporates the thinking of a number of value-style
money managers. The strategy is easy to follow, but you’ll need a
calculator to perform a few simple computations.
for this approach is the typical value manager’s willingness to look
beyond a company’s current problems to its likely results two or three
years down the road. Its use is not restricted to troubled firms, but it
works best with companies that have been in business long enough to amass
a significant track record, say seven or eight years minimum.
companies’ results are suffering due to the weak economy. So, to
demonstrate the process, I’ll assume that the economy will recover by
2003, and by then, most non-tech companies will resume their pre-recession
trends. I’ll make the same assumption for tech stocks, except I’ll
ignore their accelerated 1998-1999 period growth trends, because they were
due to unusual circumstances that are unlikely to be repeated. In all
instances, I’ll ignore data from 2001, since that represents the
“problem” that we want to “look beyond.” Once you understand the
process, you can easily modify it to suit your views.
target prices consists of four steps:
sales in 2003
the profit margin
2003 earnings and convert total earnings to earnings per-share
target prices based on a range of likely price/earnings (P/E) ratios
pharmaceutical maker Alpharma (ticker ALO) to describe the process.
We’ll use Microsoft’s MSN MoneyCentral as our resource. Finding the
needed data the first time is involved, but once there, it’s easy to
look up additional stocks. Start from MoneyCentral’s main page (moneycentral.msn.com)
by getting a stock
quote, then choose Financial
Results under Research (left-menu), and click on
Key Ratios. Next, click on Statements
(left-menu) and finally, select 10-Year
Summary from the Financial Statements dropdown menu.
We’ll forecast Alpharma’s 2003 sales based on its long-term sales
history. The Income Statement summary lists annual sales going back 10
income statement shows that sales grew in eight of the past 10 years.
Sales increased by about $137 million in 1999, and another $177 million in
2000, bringing its year 2000 sales total to $920 million. Averaging the
two most recent growth figures, I estimated that Alpharma’s sales would
increase, on average, around $150 million each year from 2001 through
2003, bringing the year 2003 sales total to $1,370 million (Print out the
10-year summary because you’ll need it later).
Alpharma’s 2003 net profits (earnings) can be determined by multiplying
your estimated 2003 sales by the net profit margin, which you can estimate
from its 10-year history. Click on Key Ratios (left-menu) and then select
10-Year Summary to see the historical profit margins. Alpharma’s margins
were spotty until 1997, and then they climbed steadily from 3.5 percent
that year to 6.6 percent in 2000. Based on that history, I estimated that
Alpharma’s margins in 2003 would be at least six percent. I multiplied
the $1,370 million estimated sales by six percent to arrive at $82 million
estimated earnings in 2003.
Convert to EPS
You can convert your forecast to earnings per share (eps) by dividing the
total earnings by the your estimate of the number of shares outstanding at
the end of 2002. The number of shares outstanding at the end of each
fiscal year is listed in the 10-Year Summary report that you printed
earlier. The number of shares grows over time as firms issue additional
stock to raise money, make acquisitions, or to provide employee stock
options. Alpharma had 29.9 million shares outstanding as of December 2000,
and based on its history, I estimated that Alpharma would likely add
around one million shares annually resulting in 33 million shares out by
December 2003. Dividing the $82 million estimated earnings by 33 million
shares yields $2.49 estimated eps in 2003.
Estimate P/E to Find Target
The target price is simply the forecast eps (i.e., $2.49) multiplied by
the expected 2003 P/E ratio. What P/E should you use? Most value managers
that I talked to recommend referring to a company’s own historical
valuation ratios for guidance, instead of looking to the overall market or
to other companies within the same industry. A P/E ratio reflects the
markets’ enthusiasm about the stock, and each company has its own sizzle
lists Alpharma’s average P/E ratio for each of the past 10 years on the
Key Ratio report, the same report containing the profit margin history.
Alpharma’s P/E mostly ranged between 25 and 35 over the 10 years.
Multiplying those P/Es by the $2.49 estimated earnings gives you a price
target range of $62 to $87. Alpharma’s shares were recently trading
around $24, so there’s plenty of upside potential if my assumptions hold
Watch Out for Techs
I had to search to
find a company with Alpharma’s potential to use for this example. Many
stocks, especially techs, didn’t show much promise.
Systems for instance. Based on my estimate of $32 billion in sales for
Cisco’s fiscal year ending in July 2003, and a 17 percent profit margin,
I came up with $5.4 billion profit or $0.68 per share (7.9 billion
shares). Estimating the P/E at 28 to 40 yields share target prices ranging
from $19 to $27. That’s not encouraging considering the stock traded at
$21 last week.
target prices may sound involved, but it will only take you a couple of
minutes once you get the hang of it. I described using target prices to
evaluate investment candidates, but you can also use them to help you
decide when to sell stocks that are already in your portfolio.
are only part of the equation, of course. You still have to analyze each
company’s prospects in detail.