It’s important to set price targets on your stocks the day you purchase them.
Your target should be based on the P/E of your stock, multiplied out by expected future earnings. I recommend that you at least think about what price your stock can achieve within 18-24 months. And that should at least be a 30%-50% gain. If it doesn’t have that potential, keep looking.
Going forward, when the stock hits your target price, reevaluate it and determine if it has the ability to continue double-digit price gains or if you would gain more by cashing in now and using those funds to purchase a different stock with more potential. Many analysts make this decision easy for you, by providing targets for their recommendations, and often cash in just a portion of the holding to take some profits and let the remaining share ride toward a new target.
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When I speak at Money Shows across the country, I am frequently asked about how I set my price targets. If it’s not the most common question I get, it’s certainly up there in the top five.
First of all, I can’t emphasize too strongly that it is essential to set a target price at the time you buy a stock. If you don’t, then how the heck do you know when your stock has appreciated enough to sell it?
I always ask my workshop attendees how many set price targets on their stocks, and I never see more than two or three hands go up. That’s a shame, but I think it’s because folks just don’t know how to set targets, rather than them not wanting to. So, let me tell you how I do it, but keep in mind that, like all investing, it is not black and white. It’s a combination of science, art and experience. But most of all, it’s easy! No complicated math here—just a few assumptions.
Let’s walk through an example step by step. For this example’s sake, we’ll set your holding period at three years, max.
Setting Price Targets for Your Stocks
You’ve done your research and have selected the stock you want to buy—the (theoretical) Widget Co. The price of the stock is $10 per share, the company made $2 per share in the last four quarters, so its price-earnings ratio (P/E) is 10 divided by 2, or 5.
The company’s earnings have been increasing at a 20% annual growth rate for the past five years. With a little calculation, you can project out over the next three years, and if that same growth rate continues, the company’s earnings will look like this:
Year 1: 2.00 x a 20% increase = $2.40 per share
Year 2: 2.40 x a 20% increase = $2.88 per share
Year 3: 2.88 x a 20% increase = $3.46 per share
So, at year 3, your company is earning $3.46 per share. Now, if its P/E ratio remains the same (5), the projected price of the shares can be found by mere substitution into the P/E equation, and solving for P:
P divided by E (3.46) = 5. So, a little algebra later, P = 17.30. Wow—that’s a 73% gain! Most investors would be tickled pink by that.
However, should you believe that the company’s earnings may grow even faster than 20% annually, due to some event such as a tremendous new product, gains in market share, new markets, etc., or that one of those occurrences might drive the company’s price greater than 17.30 (even without the requisite earnings growth), you would be even happier.
To be on the safe side, it’s also smart to calculate what would happen should the Widget Co. not grow as quickly over the next three years as it had for the past three.
Easy as 1-2-3, right? OK, it’s time to practice this exercise. I’ve shown you each step of the process in the following worksheet, so you can see exactly how I’ve come up with these projections (http://finance.yahoo.com is a convenient place to find the multiples and growth rates for the calculations below).
Doing the Math on Price Targets
COMPANY NAME; SHARE PRICE: Widget Co.; $10.00
P/E: 5
EPS (last 4 quarters): $2.00
Yahoo! Finance; Financials
5-year annual earnings growth rate: 20.0%
Yahoo! Finance; Analysis; Growth Estimates
Scenario 1 – Projecting future earnings growth at same rate as current
Year 1 earnings projection:
EPS x annual EPS growth rate projection (20%) = Year 1 EPS $2.40
Year 2 earnings projection:
Year 1EPS x annual EPS growth rate projection = Year 2 EPS $2.88
Year 3 earnings projection:
Year 2 EPS x annual EPS growth rate projection = Year 3 EPS $3.46
Scenario 2 – Earnings growth rate (25%) different than current rate
Year 1 earnings projection:
EPS x annual EPS growth rate projection (25%) = Year 1 EPS $2.50
Year 2 earnings projection:
Year 1EPS x annual EPS growth rate projection = Year 2 EPS $3.13
Year 3 earnings projection:
Year 2 EPS x annual EPS growth rate projection = Year 3 EPS $3.91
Scenario 3 – Earnings growth rate (16%) different than current rate
Year 1 earnings projection:
EPS x annual EPS growth rate projection (16%) = Year 1 EPS $2.32
Year 2 earnings projection:
Year 1EPS x annual EPS growth rate projection = Year 2 EPS $2.69
Year 3 earnings projection:
Year 2 EPS x annual EPS growth rate projection = Year 3 EPS $3.12
Now, you can substitute those results into the following equations to obtain the projected price of the company’s stock in three years:
Scenario 1 (current growth rate)
Expected Price = Current P/E x Year 3 EPS projection $17.30
Scenario 2 (25% growth rate)
Expected Price = Current P/E x Year 3 EPS projection $19.55
Scenario 3 (16% growth rate)
Expected Price = Current P/E x Year 3 EPS projection $15.60
And there you have it! So, now you can use a similar methodology on all of your stocks. But remember, the targets are a result of the projections you estimate, and if you alter those estimates—even a little—you will change your results. After all, I did say investing was also an art!
I hope you’ll have some fun with this and also share it with your fellow investors. I think setting a target is one of the most important ingredients for success as an investor. The process will make you very familiar with your holdings, teach you to be disciplined, and help you determine when to sell your stocks.
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*This post is periodically updated to reflect market conditions.
