Target Price Setting - A Method - Harry Domash

Don't buy a stock until you know its potential and set a target price.

A simple, 5-step process, using Oracle as an example.


By Harry Domash

Most money managers wouldn't consider buying a stock until they've set a target price, and neither should you.

Your target price is the price you think a stock will hit at a specified future date.


I'm going to describe a method that you can use to calculate target prices that is deceptively simple. It uses historical data rather than guidance from the companies themselves or Wall Street analysts. It involves forecasting a company's sales per share, and then using its historical price-to-sales ratios to set target stock prices.

To demonstrate the process, I'll compute a target price and tell you whether it's worth investing in software applications supplier Oracle

Why use sales and price-to-sales instead of earnings and price-to-earnings ratios? First, sales growth is easier to predict than earnings growth. Plus, if you look at historical data, you'll find that P/E ratios are a lot more volatile -- and thus, harder to forecast -- than P/S ratios.

Since the process is based on forecasts, and forecasts are always wrong, I won't try to set a precise target price. Instead, I'll estimate a low and high target-price range.


A five-step process

The stipulation is that the target-price date is always the day after a company reports its fiscal-year results. I call that fiscal year the target year.

Developing my target price consists of five steps:
• Estimate sales in the target year.
• Estimate the number of shares outstanding in the target year.
• Use the results from steps 1 and 2 to compute estimated target-year sales per share.
• Estimate expected range of price/sale ratios.
• Use No. 3 and No. 4 to compute the estimated target price range.

Now, we'll set a target for Oracle.
The company's fiscal year ends in May, so I'll use its 2007 fiscal year. Oracle will probably report its May 2007 fiscal year results in June or July 2007.
I've found that the calculations go faster if I first print MSN's key ratios 10-year summary and financial statements 10-year summary reports for stocks I analyze.

Step 1: Start with sales

Start by estimating a company's target fiscal-year sales. The 10-year financial statements summary shows each company's fiscal-year sales going back 10 years. Most analysts forecast sales growth in terms of year-over-year percentage increase. However, I've found that it's more useful to look at recent historical sales growth in terms of actual dollars instead of percentages.

Oracle's recent sales growth has been volatile, ranging from a $1.3 billion year-over-year gain in fiscal 2000 to a $1.2 billion drop in fiscal 2002. In its most recent fiscal year, ending in May 2004, sales climbed $681 million. I calculated Oracle's five-year average growth at $266 million, which isn't much compared to its $10.2 billion fiscal-year 2004 sales total.

Starting with Oracle's 2004 sales of $10.156 billion, I added $266 million to get $10.422 billion for 2005. Adding another $266 million results in $10.688 billion for its May 2006 fiscal year.
Finally, adding $266 million to that figure yields estimated sales of $10.954 billion for its May 2007 target year.
• Oracle target year sales: $10.954 billion
My sales estimate assumes that recent annual historical sales growth will continue. Obviously, that's not always the case. So modify your target-year sales if you have more reliable numbers.

Step 2: Shares outstanding

Next, I estimate a company's total shares outstanding at the end of its target year. Again, I use history as my guide. Many companies consistently increase their number of shares outstanding as they issue stock to raise cash, make acquisitions or allocate shares for employee stock options.

Oracle has reduced its number of shares outstanding in recent years. On average, its total dropped by 100 million shares annually over its past five fiscal years. Using that figure, I estimated that Oracle's average 5.2 billion shares outstanding in 2004 would drop to 4.9 billion by its fiscal 2007 target year.
• Oracle target year shares outstanding: 4.9 billion

Step 3: Sales per Share

Just as earnings per share is annual earnings divided by the number of shares outstanding, sales per share is annual sales divided by the number of shares out.
I estimated Oracle's target-year sales of $10.954 billion and shares outstanding at 4.9 billion. So my estimated target year sales per share ($10.954 divided by 4.9, rounded down) is $2.20.
• Oracle sales per share: $2.20

Step 4: Price/sales ratios

Investors frequently compare valuation ratios to evaluate the relative merits of companies in the same industry. For instance, Company A is the best buy if its P/E is only 20, while Company B's P/E is 35.
Competing firms often consistently trade at different valuations depending on their popularity with investors. For instance, pharmaceutical maker Pfizer (PFE, news, msgs) almost always trades at higher valuations than competitor Merck (MRK, news, msgs). This is true no matter what valuation ratio you choose. In terms of price/sales ratios, Pfizer's 6.6 average P/S over the past five years is almost double Merck's 3.5 figure. Similarly, chip maker Intel (INTC, news, msgs) has traded at an average 5.8 P/S over the past five years compared to 1.3 for competitor Advanced Micro Devices (AMD, news, msgs).
Thus, instead of comparing valuation to the overall market or to its sector, I've found that a stock's own history is the best indicator of its likely future trading ranges.
MSN's Key Ratios report shows the average annual price/sales ratios going back 10 years. I think the most recent five years' data are the most relevant, and that's what I use to determine the range of anticipated P/S ratios at my target date.
Over nine of the past 10 years, Oracle has traded at P/S ratios ranging from 4 to 7.9. However, in its May 2000 fiscal year, MSN lists its average P/S at 20. It's best to ignore an obviously out-of-range figure.
Disregarding the 2000 figure, Oracle's last five P/S ratios ranged from 4 to 7.9.
• Oracle target P/S: 4 to 7.9

Step 5: Doing the numbers

If you remember your algebra, you'll know that share price can be calculated by multiplying the sales per share by the price-to-sales ratio. For instance, a stock would be trading at $20 if its sales per share were $10, and the P/S ratio was 2 (it works: price/sales = 20/10 = 2).
Target Price = sales x P/S
In step 3, I estimated that Oracle would have sales of $2.20 per share. In step 4, I estimated its price/sales range at 4 to 7.9. Multiplying by sales per share by P/S:
• Oracle target price range: $8.80 to $17.40.
Oracle recently changed hands at $11.70; already within my $8.80 to $17.40 summer 2007 estimated trading range. I'd abandon Oracle for better prospects.

This simple target-price calculation is intended to help you evaluate stocks that you're researching. But it doesn't take changing economic or competitive conditions into account. In short, it's no substitute for doing your own due diligence.


Domash publishes the Winning Investing stock and mutual fund advisory newsletter and writes the online investing column for the San Francisco Chronicle. Harry has two investing books out, the most recent being "Fire Your Stock Analyst," published by Financial Times Prentice Hall.


Source: http://articles.moneycentral.msn.com/Investing/SimpleStrategies/FindStocksWithMoreProfitPotential.aspx