At what price am I willing to sell this stock?
This is a great question to consider before you ever buy or hold shares in any particular company. Determining the prices at which a stock is undervalued, fairly valued, and excessively priced, is the first step in deciding on a credible target price for a specific time horizon.
A famous rule of ‘safe’ forecasting is to never put both a price and a date into the same prediction.
Forecasting a price without a date means you can never be wrong. For example, if you predicted that Apple (AAPL) was ‘on the way to $1,000’ you could still be correct as long as you had not specified a date for attaining that milestone.
Some, but not all, research firms give ‘fair value’ estimates and/or 12-month price targets. When they are provided, the firms rarely disclose how they arrived at their numbers.
Here are my steps for setting a 12-month goal.
Accomplishing those tasks is tougher than it appears.
My favorite sources for establishing typical P/E multiples are the Value Line Investment Survey and Standard & Poors research. They often give very different viewpoints on the same historical data. Value Line shows ‘average annual’ P/Es for each stock during the past 10 – 15 years. S&P gives the ‘annual high and low multiples from the most recent decade.
Here are excerpts from both sources' research reports on Whole Foods Market (WFM) in regard to historical Price to Earnings ratios:
In the wild market of 2008, Whole Foods shares ranged from a high of $42.50 to a low of $7.00. S&P’s indicated P/E range lists from 9 to 52. That assumed you had accurately predicted its earnings. That would have been difficult in FY 2008. EPS on this growth company dropped from $1.29 to $0.82 as the recession took hold.
Value Line’s average annual P/E for 2008 is listed as 40.4x. That number reflected a time-weighted average price of $33.13 on the fiscal year earnings that finally unfolded.
The takeaway lesson? Even mathematically simple ratios involve judgment calls as to what true ‘normal’ is. That’s why computer generated stock picking has never proven superior to techniques employing human input. Annual averages often mask huge intra-year swings in P/E. That is due to the combination of price fluctuations plus changes in corporate profitability.
10-year median multiples can correct for near-term valuation volatility just as moving averages smooth out daily price variations. Value Line calculates this number for you at the top of each full page report they publish. They also show a hybrid (most recent 6-months’ actual + next six months’ projected EPS) Price to Earnings ratio [the largest, bolded P/E number] along with the standard trailing 12- month number.
Obtaining earnings estimates is relatively easy. Yahoo Finance, MSN Money Central, Zacks, Morningstar, Value Line, Standard & Poors and others all supply forward projections.
What are the problems? These sources don’t always agree on the numbers. Even when they do, those estimates may prove to be inaccurate. Some companies are fairly predictable, while others have a history of making earnings forecasts seem more like guesses.
Value Line provides each company a percentile ranking in the category of ‘earnings predictability’. Value Line's worst percentile rating is 5 and their highest percentile ranking is 100, as defined below.
Whole Food Markets rates a mediocre 60 in this metric. Less volatile stocks like Coca-Cola (KO) and Kellogg (K) rate in the top 1%. Highly cyclical US Airways Group (LCC) merits only a 5.
Using low predictability estimates in establishing target prices can lead to huge misses in terms of future share price action. The GIGO (Garbage In, Garbage Out) principle definitely applies to these low-predictabilty companies. Investors need to to question all assumptions.
Consensus estimates for Whole Foods’ 2013 fiscal year are now centered on $1.45 (FY ends Sep. 29, 2013). That estimate along with a regression to its 10-year median P/E suggests a split-adjusted goal price just above $49 (around $98 on the pre-split basis). WFM closed on June 28, 2013 at $51.47. The shares appear more than fully priced at today's quote using my method for analysis.
Will WFM meet estimates? Is a 34 P/E a conservative assumption? Only time will tell. This was simply an exercise to illustrate a logical method to determine rational price targets. Every projection depends on assumptions that may, or may not, play out as assumed.
Shares in companies with hard-to-predict earnings per share (EPS) and highly variable P/Es (price/earnings) are particularly volatile. Be sure to get paid for the extra risk. Companies with high predictability and stable multiples are generally safer and less volatility. Bargain prices in those stocks most often come during broad market selloffs.
A good stock market guru doesn't paint himself into a corner by assigning dates to price predictions. He leaves the future to unfold on its own schedule.
Disclosure: Long KO shares, Short KO covered calls