How To Calculate Target Prices For Your Stocks

14th Dec '24 by Roland Head

18 comments 1922 reads

What’s a stock really worth? In an effort to answer this question, City analysts will generally produce target prices for the shares they cover.

These prices are calculated using a range of techniques. Broadly speaking, we can see them as the analysts’ best estimate of a fair value for the company, made without relying solely on market price discovery or valuation multiples.

Stockopedia subscribers can find the latest consensus target prices for each stock at the bottom of the StockReport, alongside detailed earnings estimates.

Here’s an example for FTSE 100 stalwart Lloyds Banking Group, showing the gap between the target price and current price. An estimated long-term growth rate for the business is also included, to give some context to the basis for the price target.

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As with earnings forecasts, these target prices can be subject to regular revision. Although I don’t use them to make trading decisions, I find they can provide useful extra information and context when I’m analysing a company.

For example, when a stock I’m interested in is trading above its target price, possible explanations include:

The shares are starting to look (too) expensive;
The company is benefiting from strong momentum and broker estimates may be stale. As Ed highlighted in his article last week, this can create profitable buying opportunities.

However, I often find that broker target prices are of limited use to me because I don’t know how they were produced. For example:

What assumptions were used about future growth?
What valuation techniques were used?
Do the analysts who crunched the numbers share my view of the business and my investing perspective?

For these reasons, I’ve become progressively more interested in building my own valuation estimates for stocks that I follow. I reckon some basic valuation techniques can be a useful addition to an investor’s toolkit.

In the remainder of this article, I’m going to highlight several simple valuation methods private investors can use to build quick but useful estimates of intrinsic value.

Before that, however, I’m going to take a quick look at the academic theory behind asset valuations and the elephant in the room – discounted cash flow models.

DCF: the gold standard?

Academically, the intrinsic value of an investment is said to…

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WarrantStar

17th Dec '24

Thank you Roland. What valuation method do you suggest would be most appropriate for profitable growth company?

Skanal

Its a difficult and subjective topic. Very useful, clear and concise article. Thanks

DaviStoVest

Very helpful summary and something that I would like to come back to again when I have more time. Is there any way that I can bookmark this article within the Stockopedia system?

BnB

The article is a really good idea. But with no treatment of growth businesses, it feels like half the task has been left for another day. I use a version of the Graham formula for calculating intrinsic value of growth companies. Here it is from 1962:

$V^{*}={\cfrac {\mathrm {EPS} \times (8.5+2g)\times 4.4}{Y}}$

$V^{*}$ = the value expected from the growth formulas over the next 7 to 10 years
$EPS$ = the company’s last 12-month earnings per share
$8.5$ = P/E base for a no-growth company
$g$ = reasonably expected 7 to 10 Year Growth Rate of EPS
$4.4$ = the average yield of AAA corporate bonds in 1962 (Graham did not specify the duration of the bonds, though it has been asserted that he used 20 year AAA bonds as his benchmark for this variable^[5])
$Y$ = the current yield on AAA corporate bonds.

For Y, I substitute the US 10yr Treasury yield. And then I look at free cash flow yields and margins to compare against competitors and tweak the model. The stronger these variables, the more slack I allow the target price.

WimborneMiser

Thanks Roland, I did wonder where Stocko got their Price Targets from. I assumed it was just some Stocko ‘magic’ behind the scenes.

Personally I use a quick calculation: Profit after tax x PE ratio + Cash etc. (from Stocko balance sheet section) then divide by Average shares (again from Balance sheet section).

It’s probably not perfect or going to work for every type of stock, but it gives me a rough idea anyway

The way that I do this for profitable growth companies is based on Value = EPS * PE ratio. I spend a considerable amount of effort arriving at both the EPS and the PE ratio. I do this for separately for FY1 and FY2. I then apply a time weighted calculation to arrive at my expected intrinsic value for 12 months forward from now.

Tree

Hi Roland,

Sorry, I'm struggling to understand the improvement to the Dividend Discount Model, are you, or any other kind contributor, please able to explain how this improvement works and what I'm missing?

The original model arrives at an estimate of 2,963p. Then slightly more dividend growth in the first two years is assumed, without any reduction in the terminal growth (2.5%) or change to the discount rate (8%), but a lower estimate of 2,807.7p results. Why does assuming more dividend growth in earlier years result in a lower valuation?

And where do the 1.082 and 1.083 factors come from?

Thanks!

For the benefit of anyone else:

For my second question, the numbers are just missing a power sign, I believe. 1.082 and 1.083 should just be 1.08^2 and 1.08^3.

There's also a second typo where a / should be a - in:

"FY27 onwards: (174/(0.08/0.025))/1.083 = 2,511p"

Which should read:

"FY27 onwards: (174/(0.08-0.025))/1.08^3 = 2,511p"

Roland Head

Hi Tree,

Thank you for pointing this out. My superscript got lost in the process of copying and pasting from Google Docs. Apologies for not spotting this before I hit the button, it will be fixed shortly.

Roland

Thanks for replying and confirming.

For my first, more material, question, on why the improved estimate counter-intuitively reduces, after a bit of reflection, I think this is because the original Dividend Discount Model implicitly assumes no discounting (or growth) in the first year; it is based on a Geometric Series solution.

The improvement then explicitly is assuming discounting in the first year, and effectively adds an extra year of discounting to all years, reducing the estimate by a factor of (1/1.08). For this improvement to be an estimate on a like-for-like basis to the original I think the value should be 3,032.7p?

Alternatively, the first estimate could be adjusted instead to discount the first year. Either way though, I think discounting assumptions should be on the same basis?

Epitychia

I find it is easier to put the current share price into the formula and get out the implied rate of return. Then compare to the rate it should be offering with that degree of risk. Rather than get the implied/ target share price.

Toweller

Expectations Investing is an interesting read (link below) which turned calculating a target price on its head a little. Rather than working out a target price yourself, it suggests understanding what the market price assumes in terms of future operating cash flows vs. EV. You can then assess how accurate the market may prove to be in different scenarios, e.g. different levels/periods of growth, return on equity expectations, etc. Appreciate this approach may be less simple than you were trying to achieve in this article. Interesting read though and helped me think differently for sure https://amzn.eu/d/1gFZLpy

Redrichmond

18th Dec '24

Why do people believe forecasts. They have been wrong for 20 years plus. David Dremans book contrarian investors has a whole chapter on why Brokers forecasts are a waste of time and he concludes theres a conflict of interest . You rarely get brokers issuing a sell. Lots other books on this too

Just use a screen Fcf increasing year over year for last 3-5 years and sales increasing year over year for last 3-5 years and positive net debt (a minus) meaning they are cash rich

compare calc

fcf year last ttm x1 >= fcf 1 year ago

Fcf 1 year ago x1 >= fcf 2 years ago

fcf 2years ago x1 >= fcf 3 years ago

Same for sales

Then can tweak other metrics, like market cap over 50 million, bps spread less that 3% (300 bps). Ps less than 1 (meaning its cheap)

Then go on point and figure charts using the correct box size

I have made a fair chunk like this and then holding.

In the original version of stockopedia they had the graham value, one issue was always the 20 year aaa bond rate was wrong at 5-6% (which it is now) and you had to look it up and add it, where the value was more like 2% at the timeZ It was handy to have , I requested they add it years ago but they havnt?

You could probably use chatgpt 4.0 if you have all the parameters to calculate,

Babis DeGoogle

19th Dec '24

Well laid out and informative post Roland, thank you.

Marcus Deva

Thanks Roland very helpful for those of us (me!) not skilled enough to do DCF analysis. On working through your EPV Calcaulation I noticed an error in your figures:

Imperial’s FY24 net debt was £8,430m:

= 34340 - 8430

= £24,910m (should be £25,910m)

Finally, divide this result by the number of shares in circulation to calculate EPV per share:

= £24,910m / 837m

= 2,976p (then this results in 3096p)

I always like to check the breakdown to ensure I understand the calculations.

Thanks again

CameronR

23rd Dec '24

Greater precision doesn’t mean greater accuracy. Skip the article and go straight to the Final thoughts, which are quite good.

How to calculate target prices for your stocks

DCF: the gold standard?

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Roland Head

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