TL;DR

• Price targets indicate the future estimated value of a stock
• Analysts use popular valuation techniques such as the price-to-earnings (PE) ratio and discounted cash flow (DCF) analysis to determine a stock’s target price
• There is no guarantee that a stock will reach or fall to an estimated target price
• A stock’s price target can be a good indication of whether an investor should buy, sell or hold on to a stock

What are price targets?

Wall Street analysts set price targets for stocks on a quarterly and annual basis. These price targets reflect what the analyst thinks a fair price for the stock is based on current and past market performance. Investors often look at multiple analyst price targets as part of their due diligence. To determine a stock’s price target, analysts use various valuation methodologies to predict the company’s future earning potential. Based on the calculated price target, analysts will issue a recommendation to buy, sell, or hold the stock in question. Since the market is generally unpredictable, many investors see price targets as only a piece of the puzzle when deciding when to invest or sell stock in a company. As an investor, it helps to know how to determine and interpret price targets so you can come to your own conclusions when deciding your position on a company.

Price target methodologies

There are a few different methodologies analysts use when estimating the target price of a stock, but most of them fall into one of two categories: Relative valuation and absolute valuation.

Relative valuation:

Relative valuation uses comparable companies in an industry to determine the worth of a company’s stock. Relative valuation methods include price-to-cash flow (P/CF), price-to-sales (P/S), price-to-book (P/B) and, one of the more common methods, price-to-earnings (P/E). The P/E method multiplies two variables to calculate a stock’s price target: A P/E multiple and projected earnings-per-share (EPS). A PE multiple shows how much a company’s stock is trading for on the market compared to the company’s actual earnings-per-share. For example, if a stock is trading at $60 and its EPS is $3, the PE ratio is 20 ($60 divided by $3). In other words, investors are willing to pay 20 times the amount of earnings for this particular stock. Different industries have different average PE multiples. When analysts are trying to determine the appropriate PE multiple to use for their price target estimation, they often lean on these industry averages. The second variable the analyst will need to determine for this price target calculation is projected EPS. Analysts will often look at the company’s historical earnings growth rate in conjunction with any recent news releases to project the EPS for the next 12 months.

Here is a very simple example: An analyst is trying to determine the price target for the stock mentioned prior, which is trading at $60 with an EPS of $3. The stock belongs to a large media company and after extensive research, she concludes that the media industry’s average P/E multiple is 19. She looks at the historical financials and notices that the company’s EPS has steadily increased by 5% every year. She decides that it is likely it will increase by 5% over the next 12 months and settles on a projected EPS of $3.15. Therefore, based on the price-to-earnings method, her price target is $59.85 (19 multiplied by $3.15).

Absolute valuation:

Absolute valuation methods assess the worth of a company’s stock independent of its competitors. More often than not, this is done through a discounted cash flow or DCF analysis. The DCF analysis predicts the current value of a stock based on the company’s future cash flows. In this stock analysis, an analyst would project future cash flows for the next ten years and then in perpetuity based on estimated growth rates. She would then calculate the value of the company by discounting all cash flows back to present-day value based on a predetermined discount rate. The calculated value would be divided by the number of shares outstanding in the market and this would, in theory, give you the true value of the stock. If the calculated value of the stock is higher than its current value, an analyst might estimate a higher target price.

The problem with this technique lies in the difficulty of accurately estimating future cash flows and growth rates for the lifetime of the company. The method requires a lot of research into the company’s historical cash flow and growth, as well as an understanding of the cyclicality of the business. For example, if the company in question is new and growing rapidly an analyst may attribute an extremely high growth rate for the first five years of the DCF analysis. This may look different if the company is more mature and already experienced its high growth period. Needless to say, a lot of important variables are up to the discretion of the person performing the analysis.

Nothing is guaranteed

Regardless of whether an analyst approaches a stock analysis with a relative or an absolute valuation method, many educated guesses are required to predict the target price of a stock. There is no crystal ball, and the market is extremely unpredictable.

How to interpret price targets

A stock’s target price means very little without context. If an analyst estimates the target price of a stock to be higher than the stock’s current price, she is indicating that the stock’s current price is undervalued, or trading below its true value. In this situation, the analyst may suggest buying the stock because she believes in the potential upside. On the other hand, if an analyst estimates the target price of a stock to be lower than the stock’s current price, she is indicating that the stock’s current price is overvalued, or trading above its true value. Here, the analyst may suggest selling the stock because she believes the stock will fall in price over time.

The stock’s price target is often one of many factors when an investor is considering buying or selling a stock. Overall, it is a good indication of how the market feels about a certain company, but there is no telling what the future holds.

Bottom line

A stock’s target price is a great way to see how Wall Street feels about a certain company and its future potential. Analysts have many different methods to determine the target price of a stock, but all methods require some educated estimates. At the end of the day, when deciding whether to buy, sell or hold onto a stock, it is important to do extensive due diligence and analyzing a stock’s target price is only a piece of the puzzle.