Price Targets and ‘Multiple’ Expansion

Have you ever looked at an analyst’s price target and wondered where they came up with that number?

I have.

I hate to say it, but I’ve looked at enough price targets to conclude that -– well to conclude that I shouldn’t be looking at price targets.

I’ve seen some so far out there that I couldn’t imagine how a company could even get near it.

And at other times, so low (and seemingly unattended too) that you’re already well above it, meaning you would have gotten out, just as the biggest part of the stock’s move was getting going.

True, price targets aren’t meant to be set-in-stone promises, and they shouldn’t be used in a vacuum either. But it’d be great if they could make a bit more sense and be a little more realistic.

So here’s a way to create your own price targets.

(Note: I’ll show you a quick and easy way to create your own price targets at the end of this article. But first, let me explain the dynamics of how you can use a company’s P/E ratio to do this and why it makes sense.)

Many people use P/E ratios to determine a company’s perceived under or overvaluation.

But you can also use the P/E ratio to determine upside and downside price targets as well.

First, the P/E ratio is simply price divided by (/) earnings. For example; if a stock’s price is $30 and its earnings are $1.25, its P/E would be 24. ($30 price or ‘P’ / $1.25 earnings or ‘E’ = 24 P/E ratio)

If that stock’s earnings rose to $2.00, the P/E would now be 15.
($30 price / $2.00 earnings = 15 P/E)

And the most logical conclusion would be to see the stock’s price rise until its most recent multiple (or P/E ratio) of 24 was hit again. Why is this so ‘logical’? Because people had just been willing to pay 24 times a Company’s earnings and they probably still are, if there’s reason to believe the Company’s earnings will continue to improve.

So $2.00 (earnings) x 24 (the previous multiple or P/E ratio) = $48 (price). So the price target I’d have for that stock would now be $48. (And you could do the same thing on the downside too.)

However, P/E ratios will often times increase or decrease based on macro-economic reasons too, and not just on the stock’s own numbers. By macro-economics, I’m referring to the economy, the Indexes (broader market) and the Industries, etc.

For instance, as the economy gets better, companies will do better, and vice versa. So as things get better, an increase in earnings can be anticipated.

This being the case, people will be willing to pay more for earnings because they believe earnings will continue to rise and maybe even more aggressively. So people who were willing to pay 24 x earnings before;
($30 price / $1.25 earnings = 24 P/E) may now be willing to pay 25 x earnings ($1.25 earnings x 25 P/E or multiple = $31.25 price target). Or may be as much as 30 x earnings ($1.25 earnings x a 30 earnings multiple = $37.50 price target), etc. This is all done in anticipation that earnings will be meaningfully higher down the road. And they’re willing to pay up for them now before the earnings arrive, since these higher earnings should push prices even higher still.

One of the keys to this forecasting however, is to gauge the stock’s historical P/E ratio’s of the past, to get a better idea of the potential multiple expansion (or contraction) in the future.

Let’s say stock ABZ’s current price is $31.25 with $1.25 in earnings, for a P/E of 25. And let’s say its 5 yr. avg. P/E is 30. Moreover, let’s also say the Industry that the stock is in has started to move and is creating lots of interest. You could begin your evaluation by going back and seeing under what conditions stock ABZ scored its highest multiple (P/E) and see how the Industry’s multiple had behaved as well. (You might even want to see how the markets average P/E has changed too.)

Once you’ve determined that multiples are expanding for instance -– and based on past multiples, you’ve decided that another 5 points for your industry is reasonable -- you might conclude that another 5 points should be added to the future multiple of your stock too.

To come up with a price target, I’d take ABZ’s earnings ($1.25) and multiply it by the new multiple of 30 (25 + 5 = 30) to get my price target of $37.50.

And as earnings estimates climb, I’d continue to reevaluate my target price by reevaluating its multiple and etc. And assuming everything was the same, if earnings were now estimated at $1.50, I’d multiply $1.50 x my multiple of 30 for a new target of $45.

Of course, when predicting multiple expansions (or contractions), you should continue to pay attention to the market, the Industry, its peers and of course the stock itself, to avoid having your targets get stale.

Besides determining price targets, you can also use these ideas to find stocks on the move with potential multiple expansions.

The screen I’m running today, finds stocks with P/E’s under the average for their Industry and are under their average P/E over the last 5 yrs. But it also has to have shown an increase in its P/E over the last quarter to demonstrate its responsiveness to higher earnings which is also a part of the screen.

The Parameters

• P/E < Industry’s Average P/E

(Stocks with P/E’s that are less than the average P/E for their Industry, implying it should have room for P/E growth.)

• P/E < Average P/E over the Last 5 Years

(I want the stock’s P/E to be less that the Average P/E over the Last 5 Years.)

• Current P/E > P/E from 12 Weeks ago

(I want to see that the P/E has begun to move.)

• % Change in Actual EPS Growth Q(0)/Q(-1) >= 0 and
• % Change in Estimated EPS Growth Q(1)/Q(0) >= 0

(I included both the actual Quarterly EPS Growth and the projected Quarterly EPS Growth to make sure the stock’s earnings were moving up.)

And for good measure;

• % Change in Actual EPS Growth F(0)/F(-1) >= 0 and
• Change in Estimated EPS Growth F(1)/F(0) >= 0 and

And lastly;

• Price >= $5 and
• Volume (20 day average) >= 50,000

There are 16 stocks that made it thru this week’s screen (2/27/06).

Tip: Another way to quickly and easily determine your stock’s estimated potential price target; multiply the stock’s price by the equation: (current P/E [using 12 month actuals] / divided by its forward P/E [using 12 month forward EPS Est.].

The calculation would look like this:

Price * ((current P/E) / (forward P/E)) = future price (or price target)

In other words: let’s say a stock’s price was $50 and its current P/E was 20. Let’s also say its forward P/E was 15. Take 20 divided by 15 and you get 1.33 (i.e., 15 goes into 20, 1.33 times). Anyway, multiply the stock price by 1.33, and you get $66.50.

So again, that’s: $50 * (20 / 15) = $66.50

This makes sense because if investors are willing to pay 20 times earnings now; assuming the company’s earnings forecast looks good, why wouldn’t they be willing to pay at least that in the future.

This type of screening requires access to historical P/E ratios and forward P/E ratios. Most screeners don’t have this. But the Research Wizard does! Sign up now for a free trial to the Research Wizard and start finding stocks on the move and start creating your own price targets. You can do it. Try it today. http://researchwiz.zacks.com

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.