Harry Domash's Winning Investing



How to Set Stock Target Prices
Stock research and analysis

Dear Reader:

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 target prices. 

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.

Your analysis 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 opportunity.

There are 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.

The inspiration 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.

Currently, most 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.

Determining target prices consists of four steps:

  • estimate sales in 2003 

  • estimate the profit margin

  • compute 2003 earnings and convert total earnings to earnings per-share

  • compute target prices based on a range of likely price/earnings (P/E) ratios 

I’ll use 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. 

Estimate Sales
We’ll forecast Alpharma’s 2003 sales based on its long-term sales history. The Income Statement summary lists annual sales going back 10 years.

Alpharma’s 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).

Estimate Earnings
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 Price Range
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 factor.

MoneyCentral 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 true.

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.

Consider Cisco 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.

Computing the 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.

Target prices are only part of the equation, of course. You still have to analyze each company’s prospects in detail. 
published 12/16/01


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