Price targets are as common on Wall Street as discussion of economic data points are at Federal Reserve meetings, but they shouldn’t be a focal point during the stock research process.
Neither should price-to-earnings (P-E) ratios, as some of the biggest market winners sold at lofty P-E ratios before they even began their big moves to new highs. (To determine a stock’s P-E ratio, simply divide the stock price by the last four quarters of per-share earnings.)
But when a stock has gotten off to a great start, its P-E ratio at the breakout can be quite helpful in projecting a potential price target in which investors can actively look for potential sell signals to trigger.
Here’s how it works. IBD research shows that the P-E ratio for stocks breaking out from an early-stage base expands by an average of 130% during their run.
Projecting A Target Price
The first calculation is multiplying the stock’s P-E ratio at the buy point by 2.3 (130%). That gives you an expanded P-E ratio.
Next, take the next year’s consensus annual earnings estimate and multiply by the expanded P-E ratio. That gives a projected price target. You can also use a full-year EPS estimate that’s two years out.
Let’s take a look at Syntex in the 1960s. It was a classic “New America” stock at the time because big earnings and sales growth were being driven by a blockbuster new product: the birth control pill. It was one of Bill O’Neil’s first big winners.
The stock’s P-E ratio when it cleared a base in July 1963 was 45 (1). At the time, its annual earnings estimate was $1.67. Multiply 45 times 2.3. That gives you 103.50.
Now multiply 103.50 by the annual earnings estimate of 1.67 and that gives you 172.85. Syntex hit that target in January 1964, just before it topped (2).
P-E Ratio And Stock Leaders Today
Fast forward to today and let’s apply the formula to some current big winners.
Facebook (FB) cleared a double-bottom base in July 2013. Its P-E ratio at the 29.17 entry point was 49. Multiply 49 by 2.3. That gives you an expanded P-E of 113. At the time, analysts expected earnings in 2014 to rise to 91 cents a share. That gave investors a preliminary target of 102.83.
BitAuto (BITA), meanwhile, recently rose more than 100% above its 200-day moving average. That’s a sign the stock’s run could be nearing an end. The P-E expansion formula supports this.
When BitAuto cleared an early-stage base in August 2013, its expanded P-E was 41. Using a 2015 EPS estimate of 2.58 gave you a target of 105.78. BitAuto recently hit a high of 98.28 before pulling back.
When calculating a projected price target, don’t feel confined to the 130% P-E multiplier. If a stock clears a base in the later stages of a bull market, it might not show as much power as a stock breaking out in the early stages of a bull market.
Let’s go back to the Facebook example. Its 2013 breakout came four years into a bull market. The stock’s price target, assuming no multiple expansion, was 99.47 (49 x $2.03, the current estimate for 2015 earnings per share). Shares in October 2014 recently traded around 80.
A version of this story was initially published on Oct. 2, 2014. Follow Ken Shreve on Twitter at @IBD_KShreve
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