In my recent article 5 Steps to Protect Your Portfolio, I listed “setting price targets” as the No. 1 step to help protect your portfolio, stressing the importance of instilling a “sell” discipline that will help you realize actual, not just paper, profits.
When I speak at money shows across the country, I frequently am asked about how I set my target prices.
First, I can’t emphasize too strongly that it is 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 because folks just don’t know how to set price targets, rather than them not wanting to. So let me tell you how I do it — but keep in mind that, like all investing, setting price targets 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 of setting price targets step by step. For this example, we’ll set your holding period at a three-year maximum.
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 per share in the past four quarters, so its price-earnings ratio (P/E) is 10 divided by 2, or 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 1: $2.00 x a 20% increase = $2.40 per share
- Year 2: $2.40 x a 20% increase = $2.88 per share
- Year 3: $2.88 x a 20% increase = $3.46 per share
So, at Year 3, 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 will grow even faster than 20% annually, thanks 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; SHARE PRICE: Widget Co.; $10.00
P/E: 5
Yahoo Finance
EPS (last four quarters): $2.00
Reuters: Estimates
5-year annual earnings growth rate: 20.0%
Reuters: Ratio comparison page; growth rates
Scenario 1: Projecting future earnings growth at same rate as current
Year 1 earnings projection:
EPS x annual EPS growth rate projection (20%) = Year 1 EPS $2.40
Year 2 earnings projection:
Year 1 EPS x annual EPS growth rate projection = Year 2 EPS $2.88
Year 3 earnings projection:
Year 2 EPS x annual EPS growth rate projection = Year 3 EPS $3.46
Scenario 2: Earnings growth rate more than current rate
Year 1 earnings projection:
EPS x annual EPS growth rate projection (25%) = Year 1 EPS $2.50
Year 2 earnings projection:
Year 1 EPS x annual EPS growth rate projection = Year 2 EPS $3.13
Year 3 earnings projection:
Year 2 EPS x annual EPS growth rate projection = Year 3 EPS $3.91
Scenario 3: Earnings growth rate less than current rate
Year 1 earnings projection:
EPS x annual EPS growth rate projection (16%) = Year 1 EPS $2.32
Year 2 earnings projection:
Year 1 EPS x annual EPS growth rate projection = Year 2 EPS $2.69
Year 3 earnings projection:
Year 2 EPS x annual EPS growth rate projection = Year 3 EPS $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 3 EPS projection = $17.30
Scenario 2
Expected Price = Current P/E x Year 3 EPS projection = $19.55
Scenario 3
Expected Price = Current P/E x Year 3 EPS projection = $15.60
And there you have it! Now you can use a similar methodology on all of your stocks. But remember, the price 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 also was an art!
I never have enough time to go into this much detail at workshops, so I hope you’ll have some fun with this and also share it with your fellow investors. The process of setting price targets will make you familiar with your holdings, teach you to be disciplined and help you determine when to sell your stocks.
