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Those ratings are something of a joke around the office. How do you accumulate something if you don't buy it? And apparently there are few stocks on earth worthy of the "sell" ranking. But we've dissed the analysts ratings enough lately. If you are curious about them, see Bill Mann's excellent article, Pay No Attention to the Man Behind the Curtain, and prepare to be amazed or at least alarmed.
We don't pay much attention to analysts ratings here at the Foolish Four, although they are kind of fun to watch sometimes. The other part of the ratings game, however, is to assign a "target price." We haven't talked about that in a long time.
You often read about target prices for stocks. It sounds so macho. Investing books often suggest that you have a target price for every stock you buy. Investors can picture themselves taking aim at the elusive target price. Bang! It's in the bag and on the way to the table to provide sustenance for the family. Powerful image.
Image is everything. Meaning there isn't much to this concept other than the image. OK, it's a good idea in some ways, but it's less than useful in others and it's often misunderstood or flat out misused.
The misuse part comes when you think that the target price is your sell point. (Bang!) It's an easy assumption. If the target price for XYZ company is $50, then when you hit the target, one assumes that means it's time to sell the stock. Turn it into cash, reap your reward, bring home the bacon. In fact many investing strategies suggest that you have a sell price in mind when you buy a stock. But what happens when you follow that?
Well, as long as all of your stocks obediently rise to their target price within the allotted time, you could certainly do well by selling them when they hit the target because you would be fairly certain that the next stock you picked would rise to its target price. Sure. Selling a stock when it hits its target means you are consistently selling your winners and holding your losers. That's a bad strategy for growth stocks. (It works rather nicely for our Foolish Four stocks, though. But we have a tested mechanical system to support which winners to sell and which losers to hold.)
A target price can be useful but it needs to be a moving target. A more useful way to look at a target is as a milestone on the journey, not a destination. "Hitting" the target price, or missing it, should trigger a reevaluation the company, not dinner. Maybe you will decide to sell it, but if the company is performing as expected, it makes much more sense to calculate a new target.
Sometimes you see target prices without time frames. I've never been sure what that was supposed to mean. A target price without a time frame is like the answer I put down in high school for the speed of light: 186,000 miles. The teacher wrote "miles per year, miles per hour, miles per minute???" I missed that one but have never forgotten since that it's 186,000 miles per second. A stock that grows from $40 to $50 over a year has grown at a respectable 25% per year. A stock that grows from $40 to $50 over two years has grown at 11.8% per year. Big difference.
Here's one way to calculate a target price. Typically an analyst issues an earnings estimate at the same time as their new target price. Say a company is expected to be earning $1.00 per share four quarters from now. This year it earned $0.75 per share each quarter ($3 for the year) and is selling for $30.00. That gives it a TTM PE (Trailing Twelve Month Price/Earnings ratio) of 10.
The analyst figures that if it increases earnings to $1.00 per quarter for the next year, at the end of next year it will have earned $4.00 (TTM) and so if it is still selling at the same P/E, it would/should be worth $40.00. Voila, a target price. Yeah, it really is that simple. Once you have figured out the estimated earnings (that's the hard part) you simply invert the P/E. Instead of dividing the current price by the current earnings to get the P/E, you multiply the projected earnings by the P/E to get the projected price. Big deal, eh?
How accurate the target price is depends on the accuracy of the estimate and whether the market is still assigning the same P/E ratio to the company. Often a company that shows higher than expected growth will see its P/E ratio grow as well. If XYZ appears to be capable of growing earnings by 25% over a longer time period than just one year, the market may well decide that it deserves a higher "earnings multiple." A P/E of 25 for a company growing at 25% per year is much more reasonable than 10. That would give us a price target of $100 ($4.00 x 25), but you won't see many analysts going out on a limb and saying that a company's P/E will increase that much. (It's only technology companies with tiny earnings that get such high P/Es!)
On the other hand, the market could easily decide that companies in this particular industry are overpriced and reduce the P/E ratio across the board. Boom goes the target price even if the earnings estimate is dead on. That's why I don't find target prices particularly useful. What is useful is knowing that a company has the potential to grow earnings. Even if the market isn't in love with the industry next year, those earnings are still there being used to grow the company -- eventually, that will pay off.
Fool on and prosper!