If the stock in question is expected to post $1 in year-ahead EPS and you think they merit a 15 P/E… your share price target would be $1 x 15 = $15. Whether that $15 would represent a gain or loss would depend on where the shares were trading presently.
The chance of achieving your goal is also tied to the accuracy of the assumptions you made. How did you arrive at a ‘fair’ multiple? What level of confidence do you have that your forward estimate will actually occur?
One good source to shed light on these questions is the Value Line Investment survey. They are a subscription-based independent source of research information that’s been around since1931.
One of their best features is shown on the bottom right corner of each of their 1700 individual stock reports. Value Line assigns percentile ranks from 5 – 100 (with 100th being best) regarding the company’s:
The higher the rankings the more confidence VL has in their own projections. Financial Strength is gauged from ‘C’ to ‘A++’. A company already in default gets a ‘D’. Good financial strength, lower volatility and high earnings predictability are prized characteristics that often command premium valuations.
Earnings Predictability is the key factor to consider in whether to trust consensus views about estimates. If you see very low percentile rankings in this area you need to give more than a grain of salt when setting price targets. That’s pretty straight forward.
The correct P/E to assume is a much tougher decision. Some analyst use formulas like PEG ratios. Others simply arbitrarily assign what they think the company should trade for. I’m of the belief that the best indicator of future behavior is past history. Value Line is wonderful in making this data readily available. Here is an example using well-known money management firm Franklin Resources (BEN). The FY 2001 – FY 2011 data is what actually occurred – not somebody’s theoretical projections. Over that entire 11-year period BEN’s average P/E was 17.4x. In the four very subdued stock market years 2008 – 2011 their average multiple was 15.8x.
Why, then, does Value Line assume a 10.5x P/E for their 3 – 5 year projection? That out-of-historical-boundaries multiple is so far from what’s ever held true that I throw it out as absurd. That’s especially unlikely as Value Line thinks BEN’s EPS will grow from 2011’s $8.65 to $12.70 over the coming three-five years.
Their unsupportably low P/E assumption makes their target price laughably low based on Value Line’s own 2015-17 earnings projections. Even 15 times their longer-term EPS estimate would lead to a $190.50 median share price target.
Value Line also presumes that BEN will trade at a lower relative P/E a few years out than they’ve averaged during any of the past dozen years.
If you didn’t question their assumptions you’d probably think high-quality Franklin Resources offered no meaningful potential.
Here’s a second example which shows the inconsistency of opinion even within Value Line’s own staff. Off-price retailer TJX Companies [TJX: $44.36] sported an 11-year average P/E of 15.6x during the eleven years 2001 – 2011. Their more recent 2008 – 2011 multiple averaged only 13.3x.
In this case Value Line’s long-term view is based on an assumption of a much more realistic 15x P/E. Value Line’s modest total return projections for TJX seem to be valid based on today’s higher than typical P/E of 18.3x forward estimates for the FY ending Jan. 31, 2013.
The bottom line? Always question the way target prices have been calculated before deciding to dive into something. The rationale for the goal price may be built on quicksand.
I came across a great old quote from market savvy Edward Yardini recently. He said, “”You have to figure out how the consensus is wrong to be valuable to a client.”
Disclosure: Long BEN shares