Understanding target price

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Target price is an important value for investors, to better “understand” a stock and therefore decide to buy or sell. Basically target price is a projected price level the stock could reach, estimated by analysts or advisors.

There is no a single way to calculate target price (but assumption should be made clear by the analysis or report): but this subjectivity shouldn’t be automatically considered a downturn, since it is reasonable that the methodology is different according to factors such as industrial sector, geographical region, age of the company, market positioning, role in emerging markets and so on. In fact, there are so many factor that a case by case estimate is reasonable. The complexity also means that a private investor usually can’t easily calculate a reliable target price himself, since often he doesn’t have the quantity and the quality of information needed.

Target price usually keeps in consideration projected cash flows, to estimate company’s future incomes — and therefore dividends — to estimate stock price. Theoretically, this an ideal method, but in reality it isn’t easy to forecast future incomes. An analyst who well knows the industrial sector and has a broad view of the economic scenario can do some hypothesis on how some “enviromnental” variations (interest rates, markets, new technologies, and so on) can influence the company incomes, but he can’t foresee the future.

Another element often used to determine target price is the P/E ratio (that is the price per share divided by the annual earnings per share): the assumption is that in the medium-long term, this ratio tend to a common value (adjusted to consider risk) for all the stocks, since investor will prefer, under the condition of a same price, the company with more earnings. Therefore, an analyst could for example compare the stock P/E with the average sector or market P/E.

As we said, it’s difficult to calculate target price on your own, and therefore we have to rely on analyst and advisor reports. But it’s important to compare different analysis, since it’s needed to understand the assumptions (how solid they are). There is a very simple and fast check one can do: compare the different value of target price calculated by different analysts. If their estimates are significantly different, this mean that there may be assumptions on market scenario or on its effect on the company earnings, that aren’t so “solid” and it could be a risk signal.

Original post (in Italian): Utilizzare correttamente il target price

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