Target Price Model - Lecture

Importance of this topic

The context is application of Modern Portfolio theory (MPT).
MPT – Harry Markowitz proposed it in 1952.
The model requires expected return and standard deviation estimates for each security to be considered for inclusion in portfolio.
It also requires estimation of correlation coefficients for each possible pair of securities.
Each possible pair means, for three securities a, b, and c; ab, bc and ca are three possible pairs.
For four securities a, b, c and d; ab, bc, cd, da, ac,bd are six possible pairs

How to get expected return of a security

Target price models help us to determine the expected return.

Exp. Return =100* [Target price – Current Mkt Price]/Cur. Mkt Price

Target Price

A target price for a stock is a figure published by a securities industry person, usually an analyst.
The idea is that the target price is a prediction, a guess about where the stock is headed.
Target prices usually are associated with a date by which the stock is expected to hit the target. (normal practice 12 months)

http://invest-faq.com/articles/adv-target-price.html

The projected price level as stated by an investment analyst or advisor.
A stock trading at $60 might have a one year price target of $90.


http://www.investopedia.com/terms/p/pricetarget.asp

Target price model is a fundamental analysis technique.


Fundamental Analysis

Based on operating and financial performance of companies
Value based
Target price based
Quantitative judgment
Qualitative judgment


Past performance Basis
Projected performance basis
Judgment on positive or negative effect on future performance of news event.

Why Target Prices Are Better for Investors than a Rating?

Rick Wayman, CFA (ResearchStock.com)
http://www.investopedia.com/printable.asp?a=/articles/analyst/03/022603.asp

Because they provide additional information that an investor can use to determine if a stock is right for him or her, target prices are better than ratings.

Good Research Report

A target price is an estimate of a stock's future price based upon an earnings forecast and assumed valuation multiples.
A good research report will present its case for a target price by presenting detailed information.

Four key aspects

Investors need to evaluate the following four key aspects for determining the "legitimacy" of a target price:
1. the EPS forecast,
2. the assumptions underlying the EPS forecast,
3. the valuation multiples used, and
4. the rationale for using those valuation multiples.

How investors can judge these factors?

1. EPS Forecast

This is the foundation of the target price, and the report should contain a detailed earnings forecast model.

(full income statement with a discussion of operating cash flows) for the time frame covered by the target price (preferably two years).

A quarterly forecast for the next 12 months is useful for tracking the accuracy of the analyst and for keeping an eye on whether or not the company is performing as anticipated.

2. EPS Forecast Assumptions

The report should also discuss the assumptions used to make the forecast so that the reader can evaluate their reasonableness.
A report's lack of both a detailed earnings model and list of assumptions should be a warning sign to investors.
It is important that the assumptions be reasonable.
For example, in the current economic environment it is highly unlikely that a micro-cap company whose sales have grown at a 1-2% pace during the last two years will be able to accelerate sales growth to a double digit pace in the coming two years.

A good research report will provide the reasons why the analyst expects a big jump in sales growth
(for instance, the company may have acquired a new product or patent).
A detailed earnings model is provided so that the reader can adjust the assumptions (e.g., reduce sales growth expectations) to calculate the impact on EPS and valuations.

3. Valuation Multiples Used to Calculate the Target Price

The next building blocks of target prices are valuation multiples, such as price/earnings (P/E), price/book (P/B), and price to sales (P/S).
You need to make sure that the type of valuation multiples used are applicable to the stock you are researching.
For example, the market places more emphasis on P/E multiples for industrial companies and a P/B multiple for banks.
In addition to using the right multiples, the valuation model should be based on more than just one variable.

A valuation model based on one multiple is like a one-legged stool: not very sturdy or reliable.
While the market may place more emphasis on one multiple over another, a good model consists of at least three variables.
Three good multiples for industrial companies are P/E, P/B, and P/S.
Bank prices, on the other hand, are
typically based on P/B, to a lesser extent on P/E, and on price/total income

4. Assumptions Used to Justify the Valuation Multiples Used
Assumptions, whether they are used to support an earnings forecast or valuation target, need to be reasonable.
This can be determined by looking at the assumptions and comparing them to historical trends, a relevant peer group (i.e. companies, possibly competitors, that are in the same business), and current economic expectations.
Don't worry; this is not as hard as it sounds.
In order to make a good case for a target price, the analyst should include a discussion of the historic trends and an analysis of these trends through a comparison to a relevant peer group.
If a stock has consistently traded below its peer group average (has been a “discount”) and the forecast expects the multiples to be larger than the peers (to be a “premium”), you need to evaluate the reasons why the market is expected suddenly to “discover” the stock.

While there are occasions when valuations “pop” (such as when a company gets an FDA approval to market a drug), they are high risk/reward situations and only investors with that type of risk tolerance should accept those assumptions and invest in this type of situation.
There are situations, however, where a stock is legitimately undervalued because the market is not aware of its fundamentals—the company is literally waiting to be “discovered.”
This is a lower risk situation, but it may take a long time before the market adjusts the stock's valuation.

The Bottom Line

Investors will make better decisions if they focus on target prices, which convey more information for evaluating the potential risk/reward profile of a stock.
A good target price is based upon a reasonable set of four factors that provide the reader with information to determine the accuracy of the target price.
The absence of any of these four factors should be a red flag that the so-called report could really be a "pump and dump" marketing ploy

UBS Practices

Genzyme General
Biotechnology
United States

Our one-year price target is $32, 23 times our 2003 EPS estimate of $1.40

Daishin Securities
Securities Brokers
Korea

The target price is the average of implied fair value calculated at a 5% discount to target sector multiple.
The multiples are estimated for Trailing P/BV, 12 month Prospective P/BPCS, 12M Prosp P/CIPS, 12M Prosp. P/NORPS, FY03 P/E, and FY03 P/PpoP.

People’s Food
Food Products
Singapore

Target Price is our DCF estimate for the stock.


Aeroflot
Transport
Russia
For valuing airlines, we prefer the EV/OpFCF multiple over the more traditional P/E and EV/EBITDA ratios, as it accounts for the various balance sheet structures and depreciation methods used by different companies.
However, we believe EV/OpFCF shows only part of the picture.
We believe a more reliable valuation metric is implied franchise value of an airline, measured by comparing its enterprise value with the substitution cost of its fleet.
Hence EV/FSC is to be used.
We expect that by 2002E Aeroflot will trade at an average emerging market EV/FSC of 0.75.
Applying this to the 2002E fleet substitution cost of $2,615 m and 2002E net debt of $778 e arrive at an implied forward market capitalization of $845 m.

Sarna Chemicals,
Commodity
Europe
At our target price, Sarna would trade on 5.2x EV/EBITDA.
This represents 15% discount to the European auto parts sector.
Our valuation is supported by our DCF calculation, which derives a price of CHF2,523 per share.
We have applied a 23% discount to get our target price of 1,950 owing to (1) lack of liquidity; and (2) the relatively low capitalisation of the stock.

Sum of parts valuation

30th May 2000
Computer & Tech
Technology Software,
Hongkong
We base our 12 month price target for C&T on 20x 2002E China earnings for China Business and
50x 2002E e-commerce enabling (or GeBE) earnings.
Added to this is our valuation of the ASP division (or GeBS), which we value on 50x our 2002E revenue projections of HK$16m

P/E multiple

July 25, 2002
CNH Global N.V.(CNH)
Machinery
USA, July 25, 2002
Our 12 month target price assumes that CNH trades to roughly 10 times potential 2004 earnings of roughly $0.70 per share.


Premium over market multiple

December 4, 2002
Network Appliance (NTAP)
PC Hardware, Application software, Enterprise Hardware
United States,
We believe a normalized P/E for the market is somewhere in the low 20X range.
If we apply a 100% multiple premium (which is at the low end of NetApp’s historical range) to our estimate of NetApp’s normalized earnings of $0.40, we arrive at our price target of $18/share.

Reduction in DCF value

14 Mar 2002
The Gribbles Group (GGL.AX)
Healthcare Providers
Australia
As a result of the reduced earnings forecast, our DCF has declined to $1.00 (from $1.17), Price target $1.00 (from $1.17)

Discount to sector multiple

17 July 2002
Tamedia
Publishing
Switzerland
Our new price target of CHF 100 would value Tamedia at 6.5x 2003E EV/EBITDA, implying a discount of c20% to the European media sector.

Price/Book value multiple

10th January 2003
ESEC
Semiconductors
Switzerland
Our price target of CHF72 implies a price/book of 1.1x.
The current price at 1.6x 2002E remains well above the historical average (1998-2001) of 1.2x

Premium to sector multiple – International market

September 27, 2002
Nokia
Wireless Equipment
United States
Our price target of EUR 20 (US$20) is based on a 2003P/E of 23x, compared to European Tech at 17x.
We believe the premium is justified in view of Nokia’s superior margin, cash generation and growth outlook.