One of the first things people look at when viewing an analyst report is the stock’s target price. Also known as a “price objective,” target prices are a source of great confusion that can be dangerous to the health of your portfolio is interpreted wrong. I will try and shed some light on this topic in this article.
What It Isn’t
First of all, I would like to say that a target price is not what a stock should be trading at right now. All stocks that are rated “Buy” or some equivalent will have a target price that is higher than the current quote, so don’t assume that the stock is undervalued solely based on this. Remember that Wall Street research tends to be overly bullish, so most stocks will have rosy recommendations and higher target prices.
I think that investors should do their own due diligence and come up with their own target prices with the help of research reports. One way to do this is to take the forward consensus earnings per share and multiply it by an appropriate multiple to come up with a price. For example, if a stock is expected to earn $2.00 over the next four quarters and comparable companies trade for 20x earnings, then a logical target price would be $40 per share.
Obviously there are some big assumptions that go into this. First of all, the $2.00 per share in earnings is only an estimate that could prove to be high or low. Also, using comparable valuations is an inexact science because nobody truly knows if the competitors’ valuations are appropriate. These kinds of target prices were used during the dot com bubble to justify ridiculous price targets that were more to make the analyst famous than anything else.
Another way to come up with a target price is to use discounted cash flow analysis, but I personally think this is quite difficult for the average investor. It requires many assumptions including what discount rate to use in order to come up with a present value.
To sum it up, I think the best way to go about target prices is to look at them as a goal as long as your assumptions about the company’s fundamentals stay intact. They are not a silver bullets, but could be useful as a guide to where you think a stock will be in a year.
Target Prices: Useful Or Useless? is an article from: