Portfolio Protection Step #1:
By Nancy Zambell
Editor, Investment Digest and Dividend Digest
In my, “5 Steps to Protect your Portfolio,” I list Setting Price Targets as the #1 step to help protect your portfolio, by instilling a “sell” discipline that will help you realize actual, not just paper, profits.
I’m frequently asked about how I set my target prices. 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’s essential to set a target 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 not because folks don’t want to set targets, it’s because they just don’t know how. 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.
You’ve done your research and have selected the stock you want to buy—the Widget Co. The price of the stock is $10 per share, the company made $2.00 per share in the last four quarters, so its price-earnings ratio (P/E) is 10 divided by 2 = 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 One: 2.00 x a 20% increase = $2.40 per share
Year Two: 2.40 x a 20% increase = $2.88 per share
Year Three: 2.88 x a 20% increase = $3.46 per share
So, at year three, 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 done 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.
COMPANY NAME and SHARE PRICE: Widget Co.; 10.00
P/E (http://finance.yahoo.com):
EPS last 4 quarters (http://reuters.com; estimates): $2.00
5-year annual earnings growth rate
(http://reuters.com; ratio comparison page; growth rates): 20.0%
Scenario 1 – Projecting future earnings growth at current rate
Year One earnings projection:
EPS x annual EPS growth rate projection (20%) = $2.40 EPS
Year Two earnings projection:
Year One EPS x annual EPS growth rate projection = $2.88 EPS
Year Three earnings projection:
Year Two EPS x annual EPS growth rate projection = $3.46 EPS
Scenario 2 –Earnings growth rate different than current rate
Year One earnings projection:
EPS x annual EPS growth rate projection (25%) = $2.50 EPS
Year Two earnings projection:
Year One EPS x annual EPS growth rate projection = $3.13 EPS
Year Three earnings projection:
Year Two EPS x annual EPS growth rate projection = $3.91 EPS
Scenario 2 –Earnings growth rate different than current rate
Year One earnings projection:
EPS x annual EPS growth rate projection (16%) = $2.32 EPS
Year Two earnings projection:
Year One EPS x annual EPS growth rate projection = $2.69 EPS
Year Three earnings projection:
Year Two EPS x annual EPS growth rate projection = $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
Expected Price = Current P/E x Year Three EPS projection $17.30
Scenario 2
Expected Price = Current P/E x Year Three EPS projection $19.55
Scenario 3
Expected Price = Current P/E x Year Three 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.
