Simple Guidelines for Calculating Price Targets
Thursday, February 4, 2016

An AAII member called last week asking for guidance on how to create price targets. Though very much a fair question to ask, it is not a question that’s very easy to answer. Do a search on Google for “how to determine a stock’s target price” and you’ll get 151,000 results. You have a better chance of correctly naming this year’s Final Four men’s college basketball teams than you do of choosing the search result that will routinely give you the best guidance for setting stock price targets. (For those of you who don’t follow men’s college basketball, there is more parity this season than I ever recall seeing.)

Target prices are simply forecasts. Like any forecast, they are frequently wrong. They are also subject to revision. Since the market and the economy constantly evolve, the data used to create a price target today will be outdated tomorrow. 

More importantly, forecasts are dependent on the information fed into the model. Put bad data in and you’ll get bad data out. Even when the data comes from a reputable source, any assumptions used in the model will alter the outcome. This is a common problem with the discounted cash flow (DCF) models so often used by analysts. Seemingly small differences in the assumptions about future growth or interest rates can result in drastically different price targets. (DCF models use predictions of what a company’s cash flows will be between now and perpetuity, and then calculate how much those cash flows are worth to an investor today based on assumed rates of return.)

If the definition of a DCF model sounds complex, the actual model and its inputs are even more complicated. Wall Street analysts use DCF in part because the sheer complexity of the model gives the appearance of validity. Closely listen to a company’s earnings conference call and you’ll hear analysts asking for detailed information clearly intended to be input into their models. The minutiae make their models seem better, but I doubt that does anything to improve their forecasting skills.

I’m attacking DCF because it’s easy to do so, though I could level criticism at just about any price target model. The reason why lies in a dirty little secret Wall Street doesn’t want to reveal: Nobody knows where the market is truly headed, much less what price a stock will trade at a year from now. A stock could trade higher, it could be essentially unchanged or it could decline. A wide range of events can and will occur to move the market and the stock. Any similarity between the actual price and the forecast price should be attributed to sheer coincidence.

Fortunately, there are guidelines that can suggest whether the odds favor a stock price appreciating enough to justify the risk of investing in it. One I often use when discussing my weekly “Buy of the Week” on Chuck Jaffe’s MoneyLife podcast is relative valuation. I seek out stocks that are trading at discounted valuations relative to their five-year averages and/or their industry peers. The idea is that investors have previously shown a willingness to pay a higher price for the stock and/or a willingness to currently pay a higher valuation for its peers. (I often look at stocks with high relative valuations for my weekly “sell” candidates.)

A growth-oriented investor may look at the current valuation relative to expected future growth to seek out stocks that are trading at a discount relative to expectations. The price-earnings-to-earnings-growth (PEG) ratio works well for this. A person relying on technical analysis may use support and resistance for establishing a targeted range.

All of these are relatively easy to use and can give you a good enough price target to work of off. The key is to allow for a margin of error. Whatever price target you set is bound to be wrong; therefore, allow for enough of a discount that if you are too optimistic, you can still profit from a smaller-than-anticipated increase in the stock price. At the same time, you should realize that changes in the stock’s characteristics will require alterations to the price target in the future.

An alternative method is to forgo using price targets at all. Rather, look for stocks with attractive traits based on your style of investing (value, growth, momentum, etc.) and hold onto them as long as they continue to have those traits. Over the long term, this seemingly overly simplistic method is likely to help you realize far higher returns than any price target ever will. Eschewing target prices for this alternative method has helped us achieve long-term market-beating returns for both our Model Shadow Stock and our Stock Superstars Report portfolios.

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The Week Ahead

I will speak to our Orange County, CA chapter on Thursday and our San Diego chapter on Saturday.

Earnings season will stay near peak levels, with more mid- and small-cap companies reporting. Still, more than 60 members of the S&P 500 will release their results. Included in this group are Dow Jones industrial average components Coca-Cola (KO) and Walt Disney (DIS) on Tuesday and Cisco Systems (CSCO) on Wednesday.

The economic calendar is pretty light. The December Job Openings and Labor Turnover Survey (JOLTS) will be released on Tuesday. Friday will feature January retail sales, the University of Michigan’s preliminary February consumer sentiment survey results, January import and export prices and December business inventories.

Federal Reserve chair Janet Yellen will deliver her semiannual monetary policy testimony to a House committee on Wednesday and to a Senate committee on Thursday. San Francisco president John Williams will speak in Los Angeles on Wednesday and Dallas president Rob Kaplan will speak in Dallas on Friday.

The Treasury Department will auction $24 billion of three-year notes on Tuesday, $23 billion of 10-year notes on Wednesday and $15 billion of 30-year bonds on Thursday.

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AAII Sentiment Survey

Neutral sentiment rebounded back above its historical average as pessimism continued to pull back from its recent high in the latest AAII Sentiment Survey. Optimism declined, continuing the streak of fewer than three out of 10 investors expecting gains in the stock market.

Bullish sentiment, expectations that stock prices will rise over the next six months, declined by 2.2 percentage points to 27.5%. The drop keeps optimism below 30% for a 10th consecutive week and below its historical average of 39.0% for the 46th out of the past 48 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, jumped by 7.5 percentage points to 37.7%. This is a four-week high. The historical average is 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 5.2 percentage points to 34.7%. Since spiking to 48.7% two weeks ago, pessimism has pulled back by a cumulative 14.0 percentage points. Nonetheless, bearish sentiment is above its historical average of 30.0% for a fifth consecutive week and the seventh time in eight weeks.

The rebound in neutral sentiment occurred as the stock market has shown signs of stabilizing, at least temporarily. This week’s rebound continues an ongoing trend; since November 2014, neutral sentiment has never been below its historical average for three consecutive weeks.

Both this survey and our monthly Asset Allocation Survey show a split in the reactions of individual investors to the ongoing correction. Some AAII members have increased their cash allocations in anticipation of further declines in stock prices. (Contributing to the pessimism are the slowing pace of economic growth in China, tensions in the Middle East, the pace of economic growth in the U.S., the rate of earnings growth and prevailing valuations.) Others view the downward volatility as a buying opportunity or are looking for the opportunity to buy stocks at discounted prices. There are also many individual investors who have not made any changes to their portfolios.

This week’s special question asked AAII members how, if at all, they have recently adjusted their stock investing strategy. More than one-third of respondents (35%) said they are focusing on large-cap, income-producing and/or value-oriented stocks. Many of these respondents specifically said that they are primarily seeking dividend-paying stocks. About 14% of respondents said that they have become more conservative, particularly by increasing their cash allocations. More than 6% of those responding are buying small-cap stocks. However, nearly 30% of respondents said that they have not made any changes.

Here is a sampling of the responses:

  • “Focusing on large-cap, undervalued stocks for the next six months.”
  • “Primarily large-cap stocks for the dividends.”
  • “I remain fully invested and except for possibly minor rebalancing, I won’t be doing anything.”
  • “Holding more cash for good opportunities.”
  • “Gone to cash for the time being.”

Sentiment Survey Results for Week Ending Dec. 23:

Bullish: 27.5%, down 2.2 points
Neutral: 37.7%, up 7.5 points
Bearish: 34.7%, down 5.2 points

Historical averages:

Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
Take the Sentiment Survey.

AAII Asset Allocation Survey

Last month, individual investors increased their cash allocations to the highest level and cut their equity allocations to the lowest level in two and a half years, according to the January AAII Asset Allocation Survey. At the same time, bond allocations rose to a one-year high.

Stock and stock fund allocations fell by 2.8 percentage points to 62.5%. This is the smallest allocation to equities and the biggest monthly drop recorded by our survey since August 2013 (62.3%, down 2.9 percentage points). Even with the decline, stock and stock fund allocations remained above their historical average of 60% for a 34th consecutive month.

Bond and bond fund allocations edged up 0.2 percentage points to 17.3%. Fixed-income allocations were last higher in January 2015 (17.5%). Bond and bond funds have now risen for six consecutive months and have remained above their historical average of 16.0% for the same period.

Cash allocations rose 2.6 percentage points to 20.2%. This is the largest allocation to cash and the biggest monthly increase recorded by our survey since August 2013 (20.5%, up 2.8 percentage points). It is also the first increase in four months. Nonetheless, January was the 50th consecutive month with a cash allocation reading below its historical average of 24%.

The stock market’s rough start to the New Year caused many, but not all, individual investors to increase their cash allocations over worries about further declines in stock prices. Pessimism in our weekly Sentiment Survey has been at or above 40% for three consecutive weeks, while optimism fell as low as 17.9% last month. There may have also been some reaction to the disappointing returns realized by many equity-oriented funds last year. It is worth noting, however, that some individual investors viewed last month’s pullback as a chance to buy stocks at discounted prices or look for buying opportunities.

January’s special question asked AAII members what, if any, allocation changes they plan to make this year. Nearly one-third of all respondents (32%) said they either are not intending to make any changes or will rebalance their portfolios as necessary. Many of these respondents indicated that they are following long-term strategies. Slightly more than a quarter of all respondents (26%) said that they intend to buy stocks, particularly if prices fall to low enough levels. About 11% said that they are raising cash. Several of these respondents said they are selling stocks to do so. Approximately 10% of respondents intend to buy bonds. Some of these respondents listed their upcoming retirement as the reason for doing so. Finally, 5% of respondents either explicitly expressed their intention to invest more conservatively or stated their intention to allocate more to dividend-paying stocks.

Here is a sampling of the responses:

  • “None, my plan doesn’t change because of the market’s gyrations.”
  • “Move to cash—bonds are risky, stocks have no growth and the outlook is dim.”
  • “As some of the best stocks go down, I will use some of my cash to invest in quality and high-dividend stocks.”
  • “I plan to invest gradually as the market drops.”
  • “Potentially increasing my allocation to fixed income in light of being only four to six years away from retirement.”
  • “May use cash to buy some stocks if prices fall significantly.”
  • “None at this time, but, obviously, that’s subject to change.”
January AAII Asset Allocation Survey results:

  • Stocks and stock funds: 62.5%, down 2.8 percentage points
  • Bonds and bond funds: 17.3%, up 0.2 percentage points
  • Cash: 20.2%, up 2.6 percentage points

January AAII Asset Allocation Details:

  • Stocks: 30.5%, down 0.6 percentage points
  • Stock Funds: 32.0%, down 3.4 percentage points
  • Bonds: 4.3%, up 0.3 percentage points
  • Bond Funds: 13.0%, down 0.1 percentage points

Take the Asset Allocation Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!