Investors buy shares in the hope they rise over time and create value. The question is, by how much should a share rise, and over what timeframe, to qualify as a successful investment?

For some investors earning a 10% return in six months would be a decent result. Others may have more aggressive ambitions, perhaps 50% on a 12 to 24 month view.

There is no right or wrong answer as we each have to come to our own conclusions regarding expectations. 

Using absolute share price percentage performance is an arguable measure, albeit perhaps the ultimate arbiter, since a stock price at any moment in time really reflects market sentiment, or how investors ‘feel’ about a company’s prospects.

As you may have experienced yourselves, the market’s mood can change on a relative whim even if forecast revenues, profit and cash flow do not dramatically change.

This is where a share price target can fit in. These are subjective calculations and perhaps because of that many investors are fairly sceptical about their value. But they can act as loose goal around which your hopes and expectations
can coalesce.

A share price target can be found on most analyst research notes (although not all) and they typically signal what analysts think is a reasonable destination for a share price on the assumption that current expectations are met.

Publication of these targets have the power to move share prices. Just last week analysts at Liberum cut their share price target on engineering firm IMI (IMI) by 20%, from £12.75 to £10.20. Slowing growth and flat margins were behind the change.

IMI shares have since slipped 6.5% to £11.25, not huge but reversing the past few weeks of share price strength for the company.

DIFFERENT STROKES, DIFFERENT FOLKS

There are a number of valuation methodologies used in establishing a share price target, some relatively straight-forward like the enterprise value-to-earnings before interest, tax, depreciation and amortisation (EV/EBITDA). Others are more complex, such as the fairly common discounted cash flow (DCF).

But most investors tend to use price to earnings, or PE for short.

They are usually set around a 12 to 18 month timeframe, but can be longer or shorter-term depending on the stock.

We now show you how to set your own share price target based on some very simple sums.

One way analysts (and journalists) often summarise a stock’s valuation trajectory is to explain how a forward PE declines over time. For example, let’s assume Test Company plc’s share price is 150p and the company is forecast to deliver earnings per share of 10p in the current 12 months.

Let’s also assume analysts predict steady growth of 15% over the next few years.

On this simple basis, 10p EPS this year would rise to 11.5p in forward year one, and increase again to 13.2p in forward year two, and 15.2p in forward year three.

This might be explained something like – ‘this would mean that the PE falls from the current 15 to 13 next year, to 11.4 in year two and to 9.9 in forward year three’.

But you can flip that around and create a share price target. Since the share price should move higher to reflect rising earnings it is not unreasonable to think that the PE might remain at least stable at 15-times over the next two years.

So let’s roll that calculation forward and work it out.

As the table shows, the implied potential share price returns are impressive. Given that the market looks forward, our back of envelope sums suggest something like 50% share price upside is quite possible by the time we look towards implied earnings in forward year three.

In some cases, such steady growth might also justify a
higher PE rating than 15. In our simple example a re-rating to a PE of 18 by forward year three could imply extra upside to 273.6p. Similarly, if earnings growth was to speed up (or slow down) you are in a position to recalculate your share price target accordingly.

READING BETWEEN THE LINES

Importantly, doing your own sums means you can read between the lines of what a company is saying and judge whether current forecasts are pitched too high or low, and accommodate this in your own share price target.

Cloud-based communications technology company Gamma Communications (GAMA:AIM) is a good example of managing market expectations to the point where it frequently beats forecasts. Little IT projects firm SciSys (SSY:AIM) is another example of this habit.

But beware, many investors believe that hitting a target price is a trigger to sell a stock. We think this is a cock-eyed approach. Instead, we suggest that attaining a predetermined share price is the time to reassess the investment case.

You might decide that selling the stock is the right thing to do. You might equally end up thinking that progress has moved sufficiently forward to justify retaining the stock for future upside. There’s no one size fits all answer; it should be balanced on a case-by-case basis. (SF)

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