The Inputs of Target Prices

There are two main inputs used to determine target prices: earnings per share (EPS) forecast and valuation models. The quality of the research that an analyst or broker puts into determining these two numbers will directly impact how exact a target price will actually be. If you are using target price to glean information on whether you should buy or sell, you are on the right track. However, you should investigate the way the target price was calculated, based on its inputs, in order to truly understand if the target price is accurate or just a sales tool.

Earnings per Share Forecast

The first input into a target price is an estimated EPS, over a period of time. When you see a target price listed, you should be able to find the EPS forecast the analyst or broker used to find the target price. EPS is a term that essentially takes all of the companies earnings and divides them by the total number of shares outstanding in the company. With a forecast, the analyst is saying what they expect the EPS to be in the future, based on a number of smaller factors.

Earnings per Share Analysis

The factors used to create an EPS forecast are more important than the forecast number itself. Analysts call these factors "assumptions," because they are truly just educated guesses based on the information at hand. Your job is to see just how reasonable the assumptions are. For example, if an analyst predicts a jump from 2 percent profit increases annually to 6 percent profit increases annually, you will need to ask why. The analyst may point to the fact the corporation has recently acquired another business with profits that have been increasing at 2 percent annually as well. Combining these two profits plus factoring in economic considerations, an analyst may be reasonable in assuming the increase could be 6 percent.

Valuation Models

A valuation model is a comparison of price to other factors. For example, for a manufacturing company, a common valuation would be a comparison price to earnings, also called "P/E." A bank, on the other hand, may not have its value measured in earnings but in the total value of the assets on its book. In this case, the model would be price to book, also called "P/B." Analysts use these valuations, both at present and in a forecast, to help determine target price.

Valuation Model Analysis

As an investor, you should delve into the valuation modeling to ensure a few important things. First, it is important the analyst used a reasonable model for the industry at hand. It would be unreasonable to use a P/B model on its own with a manufacturer. However, P/B may be used in conjunction with P/E in order to gain a stable valuation of the business. Generally speaking, the more comparisons the better. You should see the analyst giving reasons why he or she things this valuation will be favorable in the future. For example, the P/B for a bank in a recession should quickly improve once the market turns.

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