Target price of a particular stock generally refers to the expected share price in a one year time period. There are many different ways to estimate the stock target price. Some methodologies are based on the cash flow analysis of the company; others are based on growth projections of the company’s business. However, most people follow a method that considers both net earnings and earnings growth expectation to calculate the 1-yr stock target price. Obviously, earnings is the profit power of the underlying company and it directly relates to company’s business model. High profit business brings good earnings, leading to a higher stock price. Based on company’s financial performance, profitability history, overall industry and specific business environment, its net earnings can be estimated using complex formulation for the coming year. Once the estimated 1-yr net earnings is determined, the company stock target price can then be readily calculated through a specific multiple called Price-to-Earnings ratio, or PE ratio.
The PE ratio is a very critical number that represents the common expectation for the underlying company and is normally determined by macro and micro economics, specific industry and various factors. In 2010, the average PE ratio for S&P 500 companies is 22.7. The perspective of US economy future will definitely affect this PE ratio, since the ratio itself indicates the common growth expectation of nation’s economy and the company for the next and coming years.
The following chart shows the average PE ratio of all S&P 500 companies in the last ten years. The specific PE ratio averages are calculated based on a 10-yr average inflation adjusted earnings in order to minimize the high yearly volatility. The historic all-time average PE ratio for over the last 100 years is 16.4, but for the past 10 years this average PE ratio has increased to 26.1, most likely due to much higher investment participation into the stock market by average investors. The PE ratio reached a peak of 43.8 in January 2000, right before the burst of Internet bubble. It then dropped to a low bottom of 13.3 in March 2009, at the worst financial crisis that had plunged US and world economy starting by the subprime mortgage disaster.
The PE ratio also varies among different types of businesses. Popular high growth technology companies such as Apple and Google enjoy hefty PE ratios, Apple – 21, Google – 24, Amazon – 72. Well established businesses often have a lower PE ratio due to slower growth perspectives, HP – 11.3, IBM – 13.2, and Microsoft – 12. For companies that have been around for 100 years such as AT&T, the PE ratio is less than 8, suggesting very limited business growth.
| Symbol | Share Price | EPS | P/E | 1-yr Target | Book Value | Price to Book Ratio |
320.61 | 15.15 | 21.16 | 370.55 | 52.00 | 6.16 | |
590.80 | 24.62 | 24.00 | 678.66 | 136.00 | 4.36 | |
177.58 | 2.47 | 71.98 | 174.12 | 14.00 | 12.5 | |
41.96 | 3.69 | 11.36 | 53.69 | 18.00 | 2.33 | |
145.00 | 11.00 | 13.18 | 150.72 | 18.00 | 8.08 | |
27.90 | 2.33 | 12.00 | 32.57 | 5.00 | 5.1 | |
29.21 | 3.68 | 7.93 | 30.93 | 19.00 | 1.53 |
It needs to be mentioned that this critical PE ratio is highly subjective, usually based on historical experience and industry wide comparison. While it is the single most important factor to determine the share price of a stock, it is nevertheless merely a collection of various opinions. The variations and change of these opinions day by day and over a period of time are driving the fluctuation and change of the stock prices.
If the target price is determined by the company’s earnings, how to define the stock price when the company is losing money? In another word, what is the stock price for a company with negative earnings? Unsurprisingly, the stock price of the money-losing companies will no doubt be depressed, and the drop depends on how deep and how long the company will operate under the negative performance. In this case, the book value of the company becomes very critical to determine the share price of the stock.
The book value is simply defined as company’s assets minus its liability in terms of share. It shows how much the company should be worth if it were for sale today without considering any earnings and growth perspectives. The book value can be considered as the bottom line value of the business. In the extreme, if the book value of the company becomes zero or negative, the entire assets of the business will be less than all its liability. The company will have to go bankrupt. Moreover, the price-to-book value ratio of a company also indicates how efficient and how profitable the company uses its assets. Once again, fast growing high tech companies usually have high price-to-book ratios, Apple – 6.2, Amazon – 12.5, and mature businesses have a much lower ratio, AT&T – 1.5.
In summary, stock target price indicates company’s future profit and growth prospective. The book value, on the other hand, shows the current worth of the company.
Simply comparing these to a working man, the future salary, bonus and all other incomes will determine his target price, and the bank savings, house properties, car and all the assets will be his book value. For woman to find a financial reliable man to marry, he must have either a prospective future incomes or a big enough asset.
No one would want a broke man with no real future income, same for the stock!
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