How is a price target determined?

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. 

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.