How To Strategically Use Target Estimate

Halal Investment Series Part 14

A Target estimate is a price that analysts believe the stock will hit. Analysts create financial models and predict the future of a stock. These models are based on predicted earnings and assumed multiples. No one can predict precisely where a stock price will be in one year. However, analyst ratings allow investors to have an understanding of the direction of the stock. We recommend you not to depend too much on analysts’ recommendations but to do your own research.   

When it comes to valuing stocks, target prices can be even more useful than equity analyst ratings. A target price, strictly defined, is an estimate of a stock’s future price based on earnings projections and assumed valuation multiples.

First and foremost, ratings have limited value because they are based on personal opinions. While one analyst may recommend a stock as a “sell,” another may suggest it as a “buy.” More importantly, a rating may not apply equally to every investor because everyone has different investment goals and risk tolerance levels, which is why target prices can be so important in rounding out research.

You should note that the accuracy of a target pricing model is only as good as the factual analysis that underpins it. While a poor thesis behind a target price can mislead investors, carefully constructed target pricing models can legitimately assist investors in evaluating the potential risk/reward profile of the stock

4 Factors Influencing Target Price:

When determining the legitimacy of a target price, investors should consider the four factors listed below:

EPS (earnings per share):

This report, which is a key component of the target price, should include a detailed earnings forecast model; including a full income statement with a discussion of operating cash flows for the time frame covered by the target price. A quarterly forecast for the next 12 months is useful for monitoring the accuracy of the analysis. and determining whether the company is performing as expected.

Assumptions for EPS Forecast:

The report should also discuss the assumptions used to make the forecast so that readers can assess their credibility. Reports lacking detailed earnings models and lists of assumptions should raise red flags. It is critical that the assumptions are sound. For example, if a micro-cap company’s sales increased by only 1% to 2% in the previous two years, it would be illogical to expect double-digit growth in the next two years. Unless, a significant event occurred, such as the launch of a new product or the approval of a patent. Investors should account for these game-changers into detailed earnings so that they can adjust their assumptions accordingly.

The following valuation multiples are used to calculate the target price:

Price/earnings (P/E), price/book (P/B), and price/sales (P/S) valuation multiples heavily influence target prices. Investors should apply each valuation multiple appropriately to the stock in question. For example, the market places a higher value on P/E multiples for industrial companies while a lower value on P/B numbers for banks. Furthermore, valuation models should be based on a variety of variables. A model based on a single multiple is like a one-legged stool—not it’s stable or dependable.

Assumptions Made to Support the Valuation Multiples used:

Assumptions must always be reasonable, whether they are used to support earnings forecasts or valuation targets. You can determine this by comparing assumptions to historical trends, peer groups, and current economic expectations.

If a stock has consistently traded below its peer-group average, but the forecast predicts higher multiples, it is critical to investigate why this stock is suddenly expected to outperform. While there may be legitimate reasons for such projections, such as FDA approval of a new drug, such a story is only suitable for investors with a high-risk tolerance.

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