If you click on the ‘Category’ ‘Stock Buy Rationale’ on my Blog Page, you should find loads of examples of where I have set Targets that you can look at to see how I do it in the Real World (WheelieDealer - Keepin’ it Reel, innit?)……
In essence there are a few ways of setting Targets - and I tend to use several of them together and come up with a Target that fits the various factors. The methods are pretty much as follows:
- P/E Ratings - The best one I find is based on using P/E Ratios (Price Earnings Ratio - basically the Share Price divided by the Earnings Per Share EPS) and I am always on the lookout for Stocks that are lowly rated on Forward P/Es around 10 or below - I find that these give the best opportunities to make the 50% plus gains. As you can see from my ‘Stock Buy Rationale’ Blogs, to set the Target it is simply a case of taking the Forward EPS Forecasts (Earnings per Share) and multiplying them by a Realistic and Sensible P/E ratio that Stocks of that ilk can justify. If in doubt, a simple way is to assume that a Quality Business that is trading well can usually get up to a P/E of maybe 15 or 16 - use these numbers to set your Target. That is really too simplistic but with experience you get to learn what kind of P/E ratings certain types of Stocks can justify - for instance, Cyclical Stocks often struggle to get a P/E over 16 whereas High Growth Tech Stocks often get P/Es over 20. P/Es are to a large extent Sector Specific and with experience you can learn what is an appropriate level - this is certainly an area where the ‘Art’ of Investing comes into play and can only be learnt by years of immersion. For a really simple rule, Buy Stocks on P/E of 10 or below and Sell when they hit a P/E of 20. Care needs to be taken with the Earnings Forecasts - try to get a sense of how realistic they are - are the growth rates consistent with what has been achieved before and any fundamental changes in the Business, for instance? Or does the Company have a history of beating forecasts? Does the Company often miss Forecasts? (if so, why are you even thinking of buying the Stock? - it is probably a right Turkey).
- Earnings Growth - I prefer Stocks on low P/Es (around 10 or below) where I can get growth in the Earnings and also P/E Multiple Expansion - this gives a Double Whammy and can drive big upside. However, sometimes a Quality Stock is on a high P/E Rating but because the Earnings grow reliably, the Stock can keep going up with the P/E Ratio staying the same. Stocks like Dunelm DNLM, Restaurant Group RTN and Next NXT have done this trick for years. For these kind of Stocks, you need to look at the EPS forecasts and just multiply them by the usual P/E ratio that the Stock commands. Sometimes you can come to the conclusion that the Forecasts are too light and you can tweak them up a bit for your Target Calculation. For instance, on Supergroup SGP, the current Consensus Forecasts for April 2017 and April 2018 are 77.09p and 88.03p but I think it is justifiable that in a few years we will see EPS of 100p. If you put this on a P/E of 20, that gives a Target Price of 2000p for SGP and it is possible they may even have a Cash Pile on top (it is always worth factoring any Cash Pile into your Calculations - I would strip out the Cash Pile when calculating the P/E Ratio). Even on the 88.03p Forecast you could justify a Target of 1750p easy (SGP is trading today at 1495p). Shove it on a P/E of 23 and you are looking at over 2000p (88.03p x 23). Needless to say I have a mountain of SGP shares and spreadbets and I will be holding tight.
- PEG Ratio - this is the P/E ratio divided by the % Growth Rate of the Profits or the % Growth Rate of the EPS which I prefer to use (they should be broadly similar). A Stock is usually seen as ‘Cheap’ if the PEG is below 1.0. For example, if a Stock is on a P/E of 16, it may seem expensive, but if it is growing at 25% a year and has done so consistently, then the PEG is 0.64 (P/E of 16 divided by 25%) which is actually quite a bargain. In simple terms, if a Stock has a P/E of 12, it needs to be growing at 12% a year - this would be a PEG of 1.0 (12 divided by 12). To set a Target using the PEG Ratio, you would work out the current PEG and then see what the Price would need to be for the PEG to rise to perhaps 1.2. For example, if the current PEG is 0.7, then the Price could rise 85% to get the PEG up to 1.2 (I’ll leave you to figure out how I calculated this !!). Therefore, if the current Price was 120p, the Target could be set at 220p ish. Utilitywise UTW is a great example of a Low PEG ratio - it is roughly on 0.5 or less at the moment - in other words strong growth but on a relatively low P/E Rating. For UTW, if the PEG rose to just 1.0 the Share Price would double……….
- Dividend Yield - In reality, this is probably the least used Factor for calculating Targets and it is more of an overlay onto other Factors which have more bearing - like the P/E Ratio. In fact, I guess this is most useful for Income Stocks where you hold them to get a certain level of Income. Let’s say you target 4% Dividend Yield on your Income Portfolio and one of your Stocks does superb and shoots up and it means that the Dividend Yield falls to perhaps 3%. In this case, would you sell it and use the money elsewhere in a Stock that delivers closer to your 4% Target for the Portfolio or would you continue to hold it? I suspect many people would accept the drop in Income (of course, in reality the Income Yield to the Portfolio would be ’locked-in’ from when you bought the Stock originally) but how about if it fell to 2%? Would it then be far better to redeploy the dosh - after all it could be gaining a much higher Income for you and locking in a real Profit at the same time (‘A Profits not a Profit until you bank it‘)? So, the conclusion of this is that for an Income Portfolio, you might set an overall Target where you say that if a Stock hits 2% Dividend Yield, you will then sell it and redeploy the Cash. Of course, when making the Decision whether to hold or not, you need to consider the Dividend Growth Rate and perhaps likelihood of any Special Dividends - these could actually make the Divvy much higher than you think in time and you would still be running the Capital Gains on Momentum. As hinted at above, I would rarely consider Dividend Yield much when looking at a normal Growth Stock in my Trading ISA. If you look at my recent Sell Rationale on Booker BOK, I had to weigh up these factors on a Stock that was in my Income Portfolio.
- NAV Discount / Premium - A few months back I bought Shares in Quintain Estates QED and I wrote a ‘Stock Buy Rationale’ Blog about it, which contains a great Real World example of where I used an NAV to draw up a Target. I think the Blog I did on Avation AVAP also uses this technique. In effect you want to be buying Stocks when there is a big Discount to NAV (Net Asset Value - I think this is often called ‘Book Value’) and you would ideally sell on a big Premium to NAV. In other words, you buy when the Stock is cheaper than its Assets and you sell when it is valued by the Market at more than its underlying Assets. Like I did in the Blogs I mentioned above, the way you Target using this Factor is to look at what other Stocks in the same Sector are trading at in terms of Premiums (or perhaps a smaller Discount) and you calculate a Target based on closing this difference. In some cases, like with AVAP, you can look at the Takeover NAV Premium if another similar Company has been bought out. In AVAP’s case, Avolon was bought at a 1.5 times Premium to its NAV - whereas AVAP is currently on a sizeable Discount to NAV. This NAV targeting method is appropriate for Property Companies first and foremost but it is also valid for Investment Trusts and Companies like AVAP where you have valuable Fixed Assets that are financed by large Debt Leasing Agreements and companies like Equipment Hire can be looked at partly in this way. Another important consideration is the likely Growth Rate of the NAV - for instance, I am expecting a fairly steady Growth Rate in the Asset Value of Empiric Student Property ESP as the company buys and develops more Buildings in coming years - in a case like this, the Discount or Premium to NAV could stay the same but the Share Price could still rise. This NAV Targeting method can be used for Investment Trusts also.
- Chart Based - As for most of these Factors, my ‘Stock Buy Rationale’ Blogs contain loads of Real Life examples of me using Charts to set Targets. In fact, I am pretty sure that every Buy Blog I have done includes a little bit on Charting which will have a Target suggested within it. In simple terms, I find the best way is to use my favourite Target Method of the simple Forward P/E Ratio as outlined earlier in these bullet points to get a rough Target and then look at the Chart and see where the Chart has Strong Resistance which is in line with this Forward P/E derived Target. For instance, let’s say the Forward P/E points to a Target of 320p on a Stock but when I look at the Chart it has a Strong Resistance Area at 310p which it has touched many times and pulled back from; I would probably decide that 310p is the correct Target to use. Really, at the risk of over simplifying, the Charting (Technical Analysis) Targets are really just a case of identifying the appropriate Strong Resistance Levels. Another Resistance Level you can use is based on an Uptrend Channel - in this method you would look at the Channel and decide that when it reached the projected Upper Line of the Channel you would set the Sell Target here. In a similar way, you could use Bollinger Bands to set Sell Targets where you would Sell when the Price hits the Upper Bollinger Band - but this would be more for Short Term Trading. Sometimes a Previous High from many years back is a good point to sell at - these kind of Long Term levels have a surprisingly powerful effect on the Price - lots of people who basically paid well over the odds (ok, it happens to us all) have waited years and years to get out at Breakeven !! By the way, this is usually a mistake and it is often better to stick with it because a Breakout of such a Long Term Resistance level could be explosive when it comes - always go back to P/E or NAV based Valuation methods and assess its Value at the Resistance Level Price.
- Shorts - my Targeting approach for Short Positions is really Chart Support based to a large extent. However, if Shorting an individual Stock (which I rarely do) then I would use the Forward P/E Ratio to get a feel of how far it can fall. For instance, if the Stock seems overvalued and is on a Forward P/E of 50, then I might decide that a realistic Target is perhaps a Forward P/E of 25 - it is best to not be too greedy and Stocks like this are probably in the High Growth and exciting Tech Sector or similar - such Stocks can often stay on silly high Forward P/E Ratios. For example, if the Stock is on a Forward P/E of 50 and priced at 550p, then a Forward P/E of 25 would mean it needs to drop to 275p - so I would then look on the Chart for Strong Support Areas around 275p. There might be one at 300p and that would make a great Target. If Shorting an Index like the FTSE100 it works in the opposite way to my Stock Buy Targets - i.e. I am using Support Areas to determine Targets as opposed to Resistance Areas. For example, if I short the FTSE100 at 5973 and the Chart has very Strong Support at 5600, then that will probably be my Target (but, as we will come onto later in this Series of Blogs), that Target might get revised once we get down to that level). Just for clarity, whatever your Target, if Shorting Individual Stocks I recommend use of a Stoploss - remember your Wins on Shorts are limited to 100% but your Losses are without Limit……..
That’s it for the second Part, the 3rd and final bit will go on about how I monitor the Targets, what to do when a Target is hit and some drawbacks of using Targets.
You can wake up now, WD.