Simple Guidelines for Calculating Price Targets

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 Since the market and the economy constantly evolve, the data used to create a price target today will be outdated tomorrow.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.