One of the more frequent questions I get is how to set a target price for a specific stock. After that, people ask me if they should buy Apple at these prices.

You can look at the chart of Apple above and see that it has had a HUGE run higher in recent months, but is in the process of digesting that run-up as it flirts with its 50-day moving average.

I thought maybe I’d answer the first question by looking at Apple. However, nothing that is written in this blog should be considered as advice to buy or sell Apple or any other specific company. The following is an exercise in how an investor looks at a company to determine if there is **potentially** enough upside in the price to warrant researching it further.

When I look at a company to see what it might be worth, I look at five different calculations to see what the stock price could potentially reach if all things stayed the same.

Please note, however, that all things never stay the same – the inputs to the formulas below are ever-changing, whether they are corporate sales, GDP, inflation, investor willingness to pay current or future valuations, average growth rates, etc.

Let’s take the easy one first – it requires no math:

**Analyst Consensus Target Price**: This is easy, you just look it up on the internet. Right now, the Analyst Consensus Target Price is $678.84. Where does this come from? Basically, all of the target prices for Apple that are published by the investment firms that follow it are averaged to come up with this number.

The upside of this methodology is that it is easy to find; the downside is that all of the various methodologies are averaged out of the process so you have no clue as to what the inputs are.

Now the rest:

**Sector P/E X Forward EPS**:

Again, this one is pretty easy. You take the valuation of its competitors in the same Industry Sector and multiply it times the projected earnings per share for the company. In this case, Apple’s competitors trade at a valuation of 19.75 times current earnings compared to Apple’s 16.73 times. The logic behind this methodology is that if Apple were to trade at the same valuation level of its competitors, based upon next years estimated earnings of $50.85 per share, Apple would be worth $1,004.29.

The upside of this methodology is that the data is easy to find on the internet; the downside is that it ignores many company-specific issues that make its valuation different from that of its competitors.

**Discounted Earnings Yield**:

The formula for this one begins to get a bit more complicated. In essence, you are calculating the future value of the earnings for the company and discounting it by the earnings yield (the inverse of the P/E ratio). The formula is a bit more complex than that, but it is another methodology that I have found useful over the years. This calculation give us a value of $928.12.

The upside of this methodology is that you can easily find the P/E ratio and calculate the earnings yield; the downside is that calculating the future value can be a bit more involved than the multiplication required in the previous method.

**Discounted Cash Flow**:

This is the most involved method I use and requires several inputs, including calculating the free cash flow for the company, determining an appropriate growth rate, calculating the weighted average cost of capital for the company, calculating the cost of the company’s equity and debt, calculating the net present value of the future cash flows, and calculating a terminal value for the company.

I generally calculate a stream of cash flows 50 years into the future for this methodology, and based upon the 50 year earnings stream, we get DCF value of $990.

The upside of this methodology is that a company’s earnings ultimately determine their stock price (which is why earnings season is so important and discussed so much on business television); the downside is that it is very involved and requires collection of a lot of data.

**The One I Learned In School**:

In my finance and investment classes a few decades ago [for those of you who remember Campbell Evans, he was my Securities teacher at Illinois Wesleyan], the way I was taught to calculate the target price was to take the current cash and marketable securities on a company’s balance sheet and add to it their current earnings multiplied by some multiple of those earnings. Generally, that multiple was the P/E ratio or the P/E ratio adjusted by the long-term growth rate for the company.

When you do the math for this methodology, you come up with a value of $1,044.94.

The upside of this methodology is that all of the information is readily available on the internet – and you can easily adjust the valuation for company specific issues buy lowering or raising the multiple to some number you believe to be more reflective of the situation. The downside is that it is simply a variation on the earlier P/E based valuation.

Oddly enough, though, many investment professionals still use this methodology to calculate their targets, but instead of the P/E they use some static multiple, like 8, 10, or 12 as their baseline then adjust up or down based upon their positive or negative view of the company’s likelihood of achieving their earnings in the future.

So, which one is better?

Each have their place – I prefer the Discounted Cash Flow because it uses the least amount of subjective information to derive the price. The biggest subjective decision you make is what to use as the growth rate for your 50 years of cash flows and I choose the most recent GDP growth rate. Others choose the current or expected inflation rate – while yet others choose a static number like 2%. I think it is more important to choose a growth rate and apply it consistently than which one you choose – just be comfortable with whatever you use and have a reasonable basis for it.

Unfortunately, it would be very difficult for the average investor to calculate the DCF value of a company so they would need to choose one of the other methodologies – or just rely upon the Analyst Consensus Target that they find on the internet.

As you can see from the numbers above, the Analyst Consensus Target is much lower than the other methodologies – and potentially for very valid reasons.

Earlier I mentioned that these were valuations in a static world where nothing is anticipated to change – it could be that the analysts have adjusted their valuations downward for some non-static events, like consumers finding some product that they prefer to iPads and iPhones, which would negatively impact Apple’s earnings in the future.

The calculations above are all based upon extrapolations of Apple’s historic numbers in some manner – and none of them include any what-if scenarios that analysts may include to provide a discount to future earnings.

We’ve all heard about the “art” and the “science” of some activity. When I calculate a target for something I am buying, I always include a discount for the unknown – in the investment world its called a Margin of Safety. Sometimes its as high as 50%, sometimes not – this all part of the “art” of investing that cannot be compensated for by the “science” which in reality is math. Obviously the math is critical, but it is not 100% of the answer.

In the end, if you are investing on your own and want to set a target, you can pull one of the above methodologies out of your pocket and calculate it or you can use the Analyst Consensus straight from the internet – but don’t ever buy something without having a profit goal in mind.

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Mark