Investing Club Mailbag: What are price targets and how do I use them?

Published Fri, Nov 25 202211:25 AM ESTUpdated Thu, Dec 1 20223:22 PM EST

I'm a (very happy) Investing Club member and would love to see a discussion of analysts' price targets. Here are my three most pressing questions: How are PTs arrived at? And why do they vary, sometimes widely, from analyst to analyst? Do the analysts actually expect the stock to reach those targets? Most important, as investors, how should we understand and utilize PTs as we manage our own portfolios and make buy/sell/hold decisions? Thanks so much. — Robbi Where do price targets come from? A price target is an analyst's best estimate of a company's fair value, and developing one is a mix of art and science. There are two methodologies most analysts use — the multiples-based approach and the discounted cash flow approach ; there are others, but these are by far the most popular and the best place to start. With a multiples-based approach, analysts will try to determine what the financial metric of choice, ideally earnings per share, will be in 12 months. When using discounted cash flow, analysts are attempting to estimate cash flows for a period of time into the future. Generally, they're looking out five years or more. The farther out they look into the future, the less accurate the estimates. Generating the estimates is the science part of the process. Once the estimates are generated, we turn to the art part. In the case of a multiples-based approach, an analyst is trying to determine a reasonable multiple she believes investors will pay in the future. Many factors will go into this determination, including peer company comparisons, historical trading trends, interest rates, growth rates, end-market dynamics and so on. In the case of a discounted cash flow model, the big question is in regard to the appropriate discount rate — also known as the required rate of return — to use. Oftentimes, analysts will use the company's weighted average cost of capital or "WACC." This is essentially the company's weighted average cost of debt, equity and preferred equity. Investors can also simply plug in their own required rate of return; the company's WACC may be 6%, but if you require a 12% for taking on the risk of ownership, 12% is your required rate of return. In other words, there is no standard for creating price targets. There is a lot left up to an analyst's discretion. This is why price targets can vary widely for the same name; there are any number of different inputs to use, plus individual estimates unique to the analyst. For the Investing Club, we generally use a multiples-based approach, either on the entire business or sometimes via a sum-of-the-parts (SoTP) analysis in which we value each segment of a business individually and then add the parts together to determine an overall price target for the stock. Consider our $150 price target on Meta Platforms (META). The current consensus estimate for fiscal year 2023 earnings is $8.10 per share. Over the past five years, shares have traded at an average of 22 times forward estimates. Of course, Meta has a few issues, including spending heavily as we head into a downturn. However, we still think shares deserve to trade closer to 18 times forward estimates given that the core business is doing quite well, management is monetizing Messenger and WhatsApp and appears to be gaining share with Reels; Meta also stands to benefit from advertisers wariness of Twitter and TikTok coming under increased government scrutiny. That multiple gives us a price target of $146 (18 X 8.10). That's in line with our published target of $150. Keep in mind there is about $12.50 net cash per share sitting on the balance sheet. Additionally, estimates could go higher if management works a bit harder on managing expenses. Plus, we're still applying a below historical average multiple. Lastly, just be mindful that price targets change constantly as new information is received and analysts update their estimates — and the multiples they are placing on those estimates or the discount rate of return (in the case of a discounted cash flow model). Do analysts believe stocks will hit these targets? The short answer is yes. After all, an analyst's reputation and job depend on being right more often than they are wrong. While stocks can move for many reasons in the short term, over the long haul they are driven by fundamentals and a diligently developed price target will be based on thorough research of the fundamentals. When it comes to developing an estimate from scratch, we would consider the research that goes into developing these estimates to be at a higher level than "back of the envelope math," as many hours go into speaking with management teams, suppliers, customers and financial modeling. There's an old saying, "Garbage in, garbage out," meaning a price target is only as good as the math and research that goes into it. For the individual investor, back of the envelope math is arguably all you need. You should always seek to do your own research, but unless you are a professional investor, it isn't likely you'll have access to management teams, or proprietary data sets and financial models. What you can do, however, is take the consensus estimate and analyze the research notes to determine if you think the analysts are missing something or are too bearish or bullish. Then you can come up with your own price target by using the consensus estimate and a multiple you believe is appropriate. At the Club, we use multiples we believe appropriate, but would certainly encourage members to consider our analyses along with their own. If you think we are being too conservative or aggressive in our view, then you should absolutely apply your own view and homework as well. After all, the ultimate goal of the Club is education, we don't want you to regurgitate our information and price targets but rather understand how we analyze and value stocks so that you may be able to do it yourself with confidence. Once you arrive at a price target, you can compare that number to the current market price. Should the market price be higher, we would determine the stock to be overpriced and avoid it. If the market price is lower than our price target, we would view the stock as undervalued and possibly take a position. How should we use price targets? Take price targets with a grain of salt. After all, not only is there the risk that the earnings don't materialize — estimates are constantly being revised as new data comes in or macroeconomic conditions change. There is also the risk that even if the estimates are achieved other investors simply don't agree with the multiple used to arrive at that price target. Multiples are impacted by interest rates and the economic outlook. If the earnings are met, but interest rates rise or the economic or company-specific outlook worsens and multiples contract, you're not going to reach the price target. For example, if you said stock XYZ will achieve $5 in earnings per share and a fair multiple is 20 times p/e, your price target is $100 (20 X 5). Now say XYZ exceeds your estimate and generates $6, but at the same time rates rise and investors aren't willing to pay more than 15 times p/e. That means the stock would only reach $90 per share (15 X 6). Of course, if the earnings aren't achieved you likely also won't see that multiple realized even should interest rates remain unchanged because investors will call into question the companies growth and future outlook. In this scenario you might be looking at $4.50 in earnings and a 17 times p/e multiple, amounting to a $76.50 share price (17 X 4.5). Understanding these dynamics allows one to incorporate a "margin of safety," which requires asking a few key questions before taking a position. The two most important: What if the earnings don't materialize; and what if the multiple I believe is fair is too aggressive? From there, you can conduct some simple scenario analyses. This is exactly what market strategists are doing right now as they attempt to determine a 2023 year-end price target for the S & P 500. They are looking at the various economic paths forward, trying to figure out a lower limit, upper limit and base case earnings number based on those projections. They will then overlay what they believe to be an appropriate multiple in each scenario based on history. It's important to note that price targets are most relevant to active investors, or those interested in the next 6 to 12 months. A more passive investor may not be well-served by placing much focus on a price target. They would do better by reading earnings releases, listening to management commentary and making a determination as to whether anything has changed at a fundamental level in regard to the long-term outlook. Since the Club has an entire team dedicated to monitoring the portfolio's holdings, we tend to take a 6-to-12-month view when considering valuation, which is predicated on company-specific research and our own world view. But again, you must do what works for you. If you can't monitor your portfolio daily or simply don't care to, then playing the shorter game may not be for you and it would be better to take a longer-term view and focus less on earnings over a 6-to-12-month time horizon. A discounted cash flow method of analysis may be more suited to you as about 70% of the fair value estimate will be based on a terminal value many years out, with near-term earnings or cash flow estimates only accounting for a small percentage of the fair value estimate. Take Apple (AAPL), our "own it, don't trade it" name. If we focus only on earnings projections for the next 12 months, we may not be as inclined to take that "own it, don't trade it" approach. We'd be trading in and out of the name quite frequently based on the China lockdowns, supplier shortages, how innovative the new iPhone is and so on. However, we instead choose to focus on Apple's place in our daily lives, the installed base (which is far from a one-quarter or one-year phenomenon), growth in services and customer loyalty metrics. These factors speak to a much longer-term trend. Sure, we may trim shares as the position gets too large based on our view that discipline trumps conviction. Or we may hold off from buying more shares if we think the stock is going to be dead money for a period of time due to nearer-term headwinds. But until those longer-term drivers of value — which also includes management's commitment to being "net cash neutral over time" — change, we are going to maintain our "own it" mantra. Our current price target on Apple is $175. If the only thing we care about is fiscal year 2023 earnings of $6.38, our implied argument is that shares should trade at about 28 times that estimate. That's a tough pill to swallow seeing shares have traded over the past five years at an average multiple of 21 times earnings (though the low was 11 times and the high was 36 times). However, in our view, given management's commitment to actually keep returning cash to shareholders via dividends and buybacks, a discounted cash flow model is more appropriate. In a discounted cash flow model, using current FactSet estimates for cash flow, terminal year EBITDA (earnings before interest, taxes, depreciation and amortization), WACC, net debt, and the current enterprise value-to-EBITDA multiple, we calculate a price target of $177.49, right in line with our published price target. In the end, price targets are just one of many factors to consider when making investment decisions. They aren't the end-all and be-all. But calculating a price target will force one to take a more objective view of the value they are getting for the price they are paying. You may love the company; a price target is going to help you determine if the price is right. (See here for a full list of the stocks in Cramer's Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

Traders work on the trading floor at the New York Stock Exchange (NYSE) in Manhattan, New York City, U.S., November 11, 2022.

Andrew Kelly | Reuters

I'm a (very happy) Investing Club member and would love to see a discussion of analysts' price targets. Here are my three most pressing questions:

How are PTs arrived at? And why do they vary, sometimes widely, from analyst to analyst?
Do the analysts actually expect the stock to reach those targets?
Most important, as investors, how should we understand and utilize PTs as we manage our own portfolios and make buy/sell/hold decisions?

Thanks so much. — Robbi