by Kevin Matras
Have you ever looked at an analyst’s price target and wonder where they came up with that number?

I have.

I hate to say it, but I’ve looked at enough price targets to conclude that — well, I shouldn’t be looking at price targets.

I’ve seen some so far out there that I couldn’t imagine how a company could even get near it.

And at other times, so low (and seemingly unattended too) that you’re already well above it, meaning you would have gotten out just as the biggest part of the stock’s move was beginning.

True, price targets aren’t meant to be set-in-stone promises, and they shouldn’t be used in a vacuum either. But it would be great if they could make a bit more sense and be a little more realistic.

So here’s a way to create your own price targets.

(Note: I’ll show you a quick and easy way to create your own price targets at the end of this article. But first, let me explain the dynamics of how you can use a company’s P/E ratio to do this and why it makes sense.)

Many people use P/E ratios to determine a company’s perceived under- or overvaluation.

But you can also use the P/E ratio to determine upside and downside price targets as well.

The two most common P/E ratios are:

P/Es using the Trailing 12 months (or 4 quarters) of Earnings and

P/Es using the F1 (or Current Fiscal Year) Estimates

First, the P/E ratio is simply price divided by (/) earnings. For example, if a stock’s price is $30 and its earnings are $1.25, then its P/E would be 24. ($30 price or ‘P’ / $1.25 earnings or ‘E’ = 24 P/E ratio.)
If that stock’s earnings rose to $2.00, the P/E would now be 15. ($30 price / $2.00 earnings = 15 P/E.)

The most logical conclusion would be to see the stock’s price rise until its most recent multiple (or P/E ratio) of 24 was hit again. Why is this so ‘logical’? Because people had just been willing to pay 24 times a company’s earnings and they probably still are - if there’s reason to believe the company’s earnings will continue to improve.

So $2.00 (earnings) x 24 (the previous multiple or P/E ratio) = $48 (price). So the price target I’d have for that stock would now be $48. (And you could do the same thing on the downside too.)

Anyway, what you’ll find is that most of the time, a stock’s P/E ratio using EPS actuals is higher than its P/E ratio using its forward estimates.

That’s because of the uncertainty regarding projected earnings vs. the certainty of actual earnings.

As the company continues to report (and meets its projections), the forward P/E ratio typically increases, which means the stock price increases as the earnings projections are coming to fruition.

And as more optimism grows over future earnings growth, you may see the P/E ratio grow even more, getting even higher than its previous multiple.

So once again, to figure out your stock’s price target, simply:

(Take the stock’s price) and then multiply it by the equation of its (P/E ratio divided by it’s / forward P/E ratio).

The calculation would look like this:

Price * ((current P/E) / (forward P/E)) = future price (or price target)

Let’s say a stock’s price was $50 and its current P/E was 20. Let’s also say its forward P/E was 15. Take 20 divided by 15 and you get 1.33 (i.e., 15 goes into 20, 1.33 times). Multiply the stock price by 1.33, and you get $66.50.

That’s: $50 * (20 / 15) = $66.50 price target

Once again, this makes sense because if investors are willing to pay 20 times earnings now; assuming the company’s earnings forecast looks good, why wouldn’t they be willing to pay at least that in the future?

The screen I’m running today finds stocks with P/Es under the average for their Industry and are under their average P/E over the last 5 yrs. The stocks also have a price target of at least 20% more than their current price.

The Parameters are:

P/E < Industry's Average P/E
(Stocks with P/Es that are less than the average P/E for their Industry, implying it should have room for P/E growth.)

P/E < Average P/E over the Last 5 Years
(I want the stock’s P/E to be less that the Average P/E over the Last 5 Years.)

Price Target >= 1.2* the current price

And for good measure:

% Change in Actual EPS Growth F(0)/F(-1) > 0

% Change in Estimated EPS Growth F(1)/F(0) > 0

And lastly:

Zacks Rank <=2

Price >= $5

Volume (20 day average) >= 100,000

This screen produces plenty of great stocks trading well under their price target.
GIII GIII Apparel Group
IMA Inverness Medical
WPI Watson Pharmaceuticals

Kevin Matras is the Research Wizard Product Manager and weekly contributing Editor at Zacks Investment Research who creates and writes the Zacks Commentary Screen of the Week. For more information, visit http://www.zacks.com/commentary/8133/What%26%2339%3Bs+Your+Stock%26%2339%3Bs+Price+Target%3F+813300

Article Source: Screen of the Week: What’s Your Stock’s Price Target?