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How is a price target determined?

Posted on Monday, June 24th, 2019 by MarketBeat Staff

Summary - A stock’s price target is the price at which analysts consider it to be fairly valued with respect to both its projected earnings and historical earnings. Analysts will typically set price targets that correspond to their buy or sell recommendations.

Price targets are significant because they help traders understand when to buy a stock as well as when to sell it. When an analyst raises their price target for a stock, it’s an indication that they expect the stock price to rise. Lowering their price target is an indication that they expect the stock price to fall. Analysts may use different time frames when setting a price target, although most will time their price targets to a one-year or 18-month period. Therefore, investors should set their own price target when determining when to enter and/or exit a trade.

In order to come up with their price target, an analyst must first determine the stock’s fair value. A common way that analysts calculate the price target for a stock is by creating a multiple of the price-to-earnings ratio. To calculate this, analysts will multiply the market price by the company’s trailing 12-month earnings. For a company that has a 12-month earnings growth rate of 10 percent and a stock that is trading at $30, the multiplier would be 1.10. Based on this information, a possible price target would be:

1.10 x 30 = $33

However, in some cases, particularly in the case of volatile stocks, analysts will look for additional guidance to either confirm their price target or make adjustments. Fundamental analysts will look at a company’s balance sheet and compare it to their historical results, current economic conditions and the competitive environment surrounding the stock.

For technical analysts, one of the most common strategies in looking for price targets is to find areas of defined support and resistance. This is done by charting a price that moves between at least two similar highs and lows without breaking above or below those points at any point in between. Once a trading range has been identified, traders can look at tools such as the relative strength index (RSI), a stochastic oscillator or the commodity channel index (CCI) to confirm whether movement within the trading range correlates with an outperform or underperform rating.

Traders make buying and selling decisions based on where a stock is trading relative to its price target. In some cases, an analyst may be setting a long-term outlook for the target. In our example above, the analyst may be projecting a price target of $33 in one year’s time. The ideal time for an investor to buy the stock would be when it was trading significantly below the target price. In an example where an analyst lowers a price target, the time to sell may be when the stock is significantly above its price target.

Introduction

Accurately forecasting price movement is based on projection and probability. Not only do analysts attempt to guess how far an asset will move from its current price, but also the likelihood (or probability) that it will move as expected. Many investors have access to a variety of fundamental and technical indicators to guide their trading. The role of the analyst is to supplement the research that investors have available to them and refine it based on their own independent and, in some cases, proprietary research. In addition to giving a stock a buy-sell recommendation, analysts will give guidance about price movement. This is known as a price target. In this article, we’ll break down what a price target is, why it is important, how a price target is determined and the limitations that investors should consider when looking at price targets. 

What is a price target?

A price target is an investment analyst’s or adviser’s estimate of the future price level of an asset, such as a stock, futures contract, commodity or exchange-traded fund (ETF). A price target is established based on a variety of criteria including the assumed supply and demand for the asset as well as a review of technical and fundamental indicators. A price target is subject to change based on new information that becomes available. A price target can be either positive or negative and is usually consistent with an analysts’ buy-sell recommendation for an asset. For example, when an analyst gives a stock an overbought recommendation, they are suggesting that the asset is reaching the point where sellers will begin to take profits, thus causing a correction. To support that recommendation, an analyst would lower their price target for the stock. Conversely, when an analyst gives a stock an oversold recommendation, they are anticipating more buyers getting ready to take a position in the asset and will most place a higher price target on the stock.

Why is the price target important?

A price target gives traders an idea of a reasonable buy or sell price for an asset. This allows them to set up entry and exit points that allow them to profit from a trade. For example, in their fourth-quarter earnings report, Company ABC, a steady utility stock, shows an increase both in revenue and in earnings per share. Furthermore, the company is predicting strong future sales growth. The company’s stock is currently trading at $22.49. Based on that information, analysts deliver a consensus buy recommendation with a consensus 12-month price target of $24.40. Traders may use that price as an exit point. Should the stock meet or exceed that level, they will exit the trade for a profit.

But what happens when the price target declines? Let’s say Company ABC is a utility that relies on a rising price for natural gas. A mild winter forecast prompts company management to lower its revenue and earnings per share numbers. Analysts respond by lowering their price target to $21.50. A trader who is willing to take a risk on a short position may see this as an opportunity to short the company’s stock.

How is a price target determined?

An asset’s price target is an analyst’s estimation of its fair market value. Analysts and financial institutions use different methods to determine a company’s valuation. Price targets and valuations will vary and are, at best, informed guesses.

Determining an asset’s fair market value can be arrived at in different ways. A common method for setting the price target is to first calculate a multiple of the company’s price-to-earnings ratio. To calculate this, analysts multiply the asset’s current market price by the company’s trailing 12-month earnings. For a company that has a 12-month earnings growth rate of 10 percent and a stock that is trading at $30, a multiple is 1.10, and a possible price target would be:

1.10 x 30 = $33

Both an analysts’ price target and buy-sell recommendation for an asset is largely impacted by a company’s output. When a company reports quarterly earnings, it gives analysts valuable information about how a company performed in the prior quarter, and more importantly, it gives analysts a glimpse into the reasons behind the performance. A company’s earnings report will also provide future guidance. This is a tricky area because in most cases, a company will try one of two approaches. For companies that are expected to report strong earnings, they may try to dampen expectations in an effort to under promise and over deliver. A struggling company, on the other hand, may attempt to paint a picture that is overly optimistic.

For this reason, analysts go beyond the information provided by the company and use either technical or fundamental metrics to determine their price target. Investors that practice fundamental analysis will look at financial statements, ratios, growth rates, free cash flow, as well as information they receive from company managers to inform their price target projections.

Technical analysts will look at momentum indicators such as the relative strength index (RSI), stochastic oscillators, Bollinger bands, and moving averages to look for trends. This is particularly important when stocks are trading in a defined range. When analysts see regular points of support and resistance, these can help them set a price target.

The limitations of price targets

One of the limitations of price targets is that analysts may use different time frames in setting a target. For example, an investor who is considering investing in Amazon (NASDAQ: AMZN) might be wondering if the stock, which is currently trading at over $1,900 per share has more room for growth. In looking at the latest analysts’ recommendations, they see that the consensus price target for Amazon was over $2,200 per share suggesting to investors that the stock still has room to grow. However, that price target was based on an analyst’s 18-month projection. An analyst that was looking at a one-year timeline may have the stock at around $1,950 per share. While still showing a profit, the investor may have been looking to sell the stock in a year and therefore may find more attractive growth opportunities.

Another limitation of price targets is the motivation of the analyst setting the target. Some analysts work for independent research firms and sell their research services for a fee. In other cases, an analyst may work for a financial institution that has an ongoing relationship with the company that the analyst is covering. Since the dot-com bubble burst in the early 2000s, analysts are much more cautious about appearing to have a bias towards the companies they analyze. However, just as an analyst may give a hold rating that really means sell, they can give a price target that is higher than what is merited. All of which is just another reason for investors to use a price target as one, but only one piece of information when deciding whether to make a trading decision.

The bottom line on price targets

Price targets are estimates that analysts use to help set expectations for an asset’s future performance. Price targets are only one piece of data that investors should use when making a buying or selling decision. A price target is closely linked to the buy-sell recommendation that analysts provide when reviewing a company’s quarterly earnings. However, like the buy-sell recommendations, price targets can be in a wide range based on the methodology being used. Fundamental analysts will tend to look at a company’s balance sheet and compare current results with their historical performance. Technical analysts, on the other hand, will study chart patterns to look for areas of support and resistance that can define price movement and therefore future price targets. One way for investors to smooth out the various analysts’ targets is by looking at the consensus estimate.  

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