Here’s a shortcut on how to come up with a price target for a stock just like the fundamental analysts do.
Many of us are familiar with the concept of the Price-Earnings (P/E) Ratio. It is often used to determine if a stock is ‘cheap’ or ‘expensive’ or considered a ‘growth’ or ‘value’ company. You hear it in the business news all the time. There is even a P/E Ratio for the S&P 500 Index!
The P/E Ratio is easily calculated:
Current Stock Price ÷ Earnings Per Share (EPS) = P/E Ratio
The most recent trailing twelve calendar months (4 full quarters) of earnings per share is generally used. The essence of the P/E Ratio is that it tells us how much the market is willing to pay for $1 of company earnings.
But the equation can also be rearranged to help us determine a future price target for a stock. If we bring the EPS over to the P/E side, the result is the following:
Stock Price = EPS x P/E Ratio
If I had the following two pieces of information:
- What will be the future earnings per share?
- What will the market be willing to pay for those earnings at that time?
I could use them in the equation and then predict stock price.
For example:
The shares of a very large and well-known digital device manufacturing company are currently trading at $90 and a P/E of 10. An analyst might look at the fundamentals of the company and expect the company to earn $11 per share over the next twelve months. He also believes that the current P/E of 10 is too low and that one year from now, when the market sees the earnings growth, the P/E will be raised to 12. Using the rearranged P/E Ratio equation, the analyst projects a one-year price target of:
$11 EPS x 12 P/E = $132 Target Stock Price
Now you know a shortcut to understanding how price targets are made by analysts and you can take your own estimates and determine a price target for yourself.