Part 2
How Do I Calculate My Own Price Targets?
For macro and fundamentals strategists, nothing plays as big of a role in coming up with a price target as earnings. The rate at which a company is expected to grow its earnings holds significant sway over the price target by impacting its price-to-earnings ratio.
The P/E ratio divides the share price by earnings per share, which is calculated by dividing the net income minus preferred dividends by the weighted average shares outstanding. The ratio can be calculated for the last twelve months, also known as trailing, and the next twelve months, also known as forward.
One of the most widely used ways to determine a price target is to calculate the company’s P/E ratio, then project how much you expect earnings to grow in the next year. These two numbers can then be used to calculate your price target.
Here’s a hypothetical example:
Assume a share is trading at $10 and you expect its earnings to grow 20% next year. The share is trading at a forward P/E multiple of 5 (if share price is $10 and earnings per share are $2).
The price target for the first year can be calculated as follows.
$2 earnings per share ✕ 20% earnings growth = $2.40 earnings per share
Assuming the P/E multiple remains at 5, then you can calculate your price target as follows:
P/E multiple of 5 ✕ $2.40 earnings per share = $12 share price next year
Another popular P/E-based method involves plugging numbers into the following formula:
Current share price ✕ (Trailing P/E multiple / Forward P/E multiple) = Price target
Market pros recommend considering all market scenarios to get a full breadth of all the things that could go right or wrong.
Of course, there are more complex ways to come up with price targets, too. Many Wall Street analysts spend hours building discounted cash flow models, which forecast changes to everything from a company’s debt obligations to net income to money paid to suppliers to calculate how much future cash flows are worth to an investor today based on assumed rates of return. Then those changes are used to derive your price target.
One of the cons of using discounted cash flow models is that analysts have to devote countless hours toward learning how to build a good model on Excel. As such, we won’t be going into details about that process. Instead, we’ll bring it all together in the next and final section.
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