An investor over time attaches some validity to his or her initial price objective, meaning that modifying that expectation becomes difficult for reasons totally contained only between one’s ears.
But stocks go where they want to, despite what any participants think is justified and despite what investors might wish would happen. Investors unable or unwilling to let go of original price opinions are doomed to lose, either through losses in positions that never come back, and/or from better opportunities elsewhere that have been lost.
There are two primary ways that investors get into trouble when setting price objectives:
How, then, does one develop a realistic price target?
As we shall see in this article, selling-price targets should be based on logical analysis, which includes several dimensions and several elements. Hope, an emotion, is absolutely not a valid part of investment decisions (to buy, sell, or hold), and should never play any part in setting a realistic exit target. Price goals based even in part on a position’s original cost basis should be avoided, since they are based on the hopes of not losing money and of being able to feel happy or smart. That being said, however, investing is an art rather than a science, so investors should work diligently to do well, but not agonize over the impossibility of achieving perfect results.
Price objectives, both when set initially and when reconsidered later, should have three elements:
This can easily be remembered conveniently as “PST,” like the whispered voice of reminder or conscience. Such a script or scenario for a stock purchase of XYZ might say, for example, that a certain new product (or expanding market share or improved margins or cost cutting, etc.) will produce earnings per share of $2.60 in 15 months, and a justifiable price-earnings ratio is 15, so in 15 months that stock should trade at $39.
If any element is missing, the story is too loosely conceived. If there is no story, or driver, the idea is probably nothing more than a chase after current momentum or a casual buy based on historical corporate charisma. If there seems to be a story but it has no clear date or goal for accomplishment, the true buying motivation may amount to no more than admiration of reputation (for example, a biotechnology company “should” have a specific drug due for approval by a predictable date).
If there is both a clear story and a related timeframe, it must also be quantifiable. One must be able to project a future climate in believable numerical terms: The earnings will be X and the price-earnings ratio reasonably will be Y, or analysts will then project a product market of Z dollars and say the company should sell at so-many-times sales, which represents its realistic attainable market target.
Lastly, when setting your price objective, you must make sure that the current market price does not reflect your thesis. Prices fluctuate because expectations (or psychology) change. Successful investing (or trading) requires correctly anticipating change. Projecting merely an extension of the present is lazy thinking. The market, meaning the crowd, is now paying (in today’s price) for what it can already envision! Your buying, and your sales-price target, should be based on a specific something additional or different. That something needs to be changed facts, more generous valuation, or improved psychology—or some combination of those.
Investors are properly schooled in understanding the central role that fundamental analysis must play in setting buying prices; in the spirit of Graham & Dodd, selling targets should equally be based on valuation. But a realistic and complete view of the investment landscape would factor technical analysis into the price target.
Suppose, again, that your fundamental analysis yields a price target of $39. But suppose that price charts clearly show a two-year-long area of prior price congestion in the $36–$38 range, followed of course by some serious price damage from the bear market. While $39 might be fully reasonable on fundamentals alone, a large number of investors and traders will honor the prior resistance below your target, making it difficult to reach your $39 without the return of a major and extended bull market. Realism would then say you should aim for $36 rather than what your fundamental work implies.
Although you can set a reasonable selling target for the stock at the outset, any target becomes subject to immediate and ongoing modification because the world does not stand still.
When reconsidering a price objective, be careful not to become greedy and turn into a cheerleader for your stock. Only new and positive information that previously was unanticipated should prompt an increase in your price target.
Good news (for instance, a new product, a contract won, strong earnings per share, a higher dividend, or even a takeover proposal) that is simply in line with your earlier reasons for buying the stock does not warrant a target price revision. Instead, you should merely note that the story part of your projected scenario is playing out and that the stock may begin to achieve your original price objective. Do not double count such newly official positives by upping your target.
Either positive or negative forces legitimately prompt reassessing price targets. However, the revisions should be studied in light of two strong caveats:
What should prompt a revision?
When examining a potential equity investment, investors make a number of assumptions, some of which they may not even be conscious of, and some of which could be wrong. Buying assumptions often include:
Each of the factors in this long list is subject to sudden or gradual change, so investors must always be ready to adjust the stock’s target sales price when any of these assumptions change.
Here are just some of the unexpected things that could go wrong, prompting a downward revision in target price:
Here are some unexpected good things that could happen, thereby implying an upward revision in target price:
Sales target prices also may need to be revised due to externalities, as economists like to call them—such as a regional war or a new worldwide oil embargo or a financial meltdown. These events can disrupt the worldwide economic picture, with bonds and stocks falling across the board, regardless of the attractiveness of specific companies, their newest exciting products, or their present bargain valuations.
In this suddenly changed scenario, price-earnings ratios generally will fall, rendering the investor’s target derived from relative price-earnings ratio now unrealistically high. One’s old target literally has become an irrelevant relic.
Another externality that can prompt a sales target revision would be a change in market psychology. Analysts cut earnings estimates or price targets; investors trim their levels of tolerable risk. On seeing signs that a major shift is occurring among institutional investors, you must assume that this new opinion or perception trend will take some time to play out; it will end with prices lower and attitudes less favorable toward your growing company than they are today.
In this scenario, one’s earnings forecast may still prove entirely correct, but the expected actual or relative price-earnings ratio has been rendered too high for the timeframe originally established for cashing in.
Psychological damage can often take a long time to repair. On a market-wide scale, our investor is looking at the bigger-picture equivalent of a company announcing good news on a day when the Dow is down 350 points on heavy volume. The positive fundamentals are swept away by the negative psychological tide of the time. So future price expectations must be adjusted downward to account for the emotional damage sustained, or one will in fact be merely hoping for the stock to reach a now-unrealistic goal.
Tactically, only the introduction of important new factors should serve to increase previously established estimates of a reasonable sale target price. A near-term jump of two points on good quarterly earnings is not a reason to raise a long-term target by $2. If truly important new information arises, expectations can be adjusted up or down.
Here is an example of truly important changes in the scenario. Suppose that an investor is attracted to a certain drug firm that has a good record of increasing earnings and that occupies a leading position in prescription preparations for diseases of the elderly, a growing population cohort. Stocks in general have been soft lately, so, as a contrarian, she senses an opportunity to buy a fundamentally attractive stock at a good price. She buys the stock at its current price of $28, and sets a target price of $35 in 18 months.
Suppose time has elapsed and other factors have not changed (unlikely), or there have been offsetting pluses and minuses that leave the target unchanged. Our holder has been lucky, and the price is now at $33.50 due, primarily, to a rising overall market.
Suddenly, a bid is made for another drug company by a major European or Japanese conglomerate. This opens a new round of potentials on the upside. The valuation numbers may get historically up to full value, but the market senses that a phase of bidding up is just starting.
Our holder might suspend temporarily her resolve to sell at $35 because the sights for all drug stocks are going to be raised. Suppose instead that a hostile bid comes in for this company. The offer is $40 and the stock goes to $41 in hopes that another shoe will drop. The investor thinks $40 is fundamentally full or even excessive, and she may well be right. But if management, normally circumspect and credible, advises shareholders not to act hurriedly and to anticipate a possible company response that could raise prices further, our holder should very temporarily suspend that standard of reasonableness by a few points and sell on the next concrete positive news.
One must remain fluid but totally logical, reacting realistically to major new items in the picture but yet not getting carried away with enthusiasm. The question, “Would I buy it now?” is always a highly useful focuser of one’s thinking regarding the sell/hold question.
The three following vignettes are not meant as praise, criticism, or recommendations. Rather, they illustrate briefly how sea changes take place that must force investors to re-do the math on target selling prices.
Until late 2007, General Electric was seemingly a one-decision stock, on the short list of must-holds for every magazine writer. Its earnings per share and dividend growth story was enviable.
It has since changed in the collective perception from a brilliantly diversified company to one widely exposed. No one foresaw that financial services’ global meltdown would shake many of its product lines at the same time. In the changed world we now face, even if the recession ends soon, sale-price targets on GE should be below former levels (if indeed they ever existed in the minds of some holders!).
Major pharmaceuticals companies have long been on the list of untouchables for their defensive characteristics. In recent years their lackluster price action created apparently attractive dividend yields. Through the market carnage in 2008 their high yields became a source of comfort and of justifying continued holding or even averaging down.
Then, in early 2009, Pfizer announced it would acquire Wyeth. Under cover of the newly widespread cutting of dividends, Pfizer recanted its recent pledge to maintain its dividend level, slashing it by about half.
In this radically new scenario, old concepts of safety and potential rebound value must be sharply re-examined. This is not the Pfizer we thought it was two years ago.
CVS, like Walgreen’s, was a dominant player in its field, operating drug and household-goods stores by the thousands and helping its growth rate via occasional sizeable acquisitions. But it faced a looming indirect threat from Washington: In a cost-containment scenario, it might see traffic reduced and/or prescription margins squeezed by pressures to contain federal and state healthcare spending.
A major positive strategic event occurred when CVS bought Caremark, thus in a stroke becoming part of the solution for cost management rather than a potential victim. Investors could justifiably revise their price-earnings ratios, and therefore price targets, upward in the new scenario.
Sale-price targets must be in mind, and written down, from the outset—otherwise there is no focus and no discipline.
But those targets must be written in pencil because both general and company-specific circumstances will almost always change. Investors also must work hard to keep egos firmly under control so that changing an original price target is not a psychological problem. The mind should remain fluid, looking for important factors to impact the equation as plus or minus adjustments of that original price objective.
It is critical, although by no means always easy, to sort out in real time the truly important from the passing and trivial. Even though they’re the hot focus of financial TV’s buzz, quarterly earnings almost always fall under the latter description! It is crucial to resist emotional tides and to take action only after the mood of the crowd has abated. The market moves to manic tops as well as to panic bottoms, so the investor must adjust targets and risk tolerances for such extremes. And at all times one must be mindful of the need to remain dispassionate by resisting the temptation to become a holder turned loyalist or cheerleader.
The critical question should be asked: “If I did not own this stock already, would I buy it today, knowing what I (and the market) do now, at the current price?”
If the honest answer is not strongly affirmative, it is time to cash in and move on.
There is no need to be loyal to any stock; it is an inanimate object without feelings to be hurt. You can change your mind and sell. If you are wrong, you can always buy back. The lower your commission expenses, the less it will cost to buy a little distance and risk insurance, even if you later do change your mind and buy back.
Keep your price targets fluid and realistic. The market will always have its own way, without regard to what your first opinion was. No need to lock in on that vision forever, because the market will not.