Question

Suppose that you are a portfolio manager for an actively managed portfolio. Your mandate is to beat a benchmark index by holding a portfolio of some subset of stocks in the index. You cannot short sell stocks or trade derivatives. You develop a quantitative model to calculate a “price target” for every stock in the benchmark index. Explain how you could use these price targets to manage your portfolio.

Answer 1

A Price Target is the projected future price level of an asset given by an advisor.It is based on the assumption of future's demand and supply and other basic qualitative and quantitative information that contributes to the financial or economic well-being and the subsequent financial valuation of a company. There is no way to know for certain what value a stock will trade at in the future because different analysts and financial institutions use various valuation methods and take into account different economic forces when deciding on a price target. Since valuation methods vary by trader or analysts, price targets will also vary. A price target is a calculated guess.

For using price targets to manage a portfolio , we need to analyse the most important factors which help for price target i.e. Earnings per share (EPS) Forecast and valuation multiples. Foundation of Price target is EPS forecast, Detailed earnings forecast model for the timeframe covered by target price. A quarterly forecast is also useful for tracking the accuracy of the analysis and whether or not the company is performing as anticipated. and assumptions on which EPS forecast model is based should be mentioned in the report so that investors can evaluate the reasonableness.

Next important factor is valuation multiples for ex P/E , P/E sales. Using of right multiple is very important as it depends on the stock.In addition to using the right multiples, the valuation model should be based on more than just one variable. A valuation model based on one multiple may not be very reliable. Therefore for a good model its better to have more than one multiples.

The discussion of the historic trends and an analysis of these trends through a comparison to a relevant peer group is very important. If a stock has consistently traded below its peer-group average and the forecast expects the multiples to be larger than the peers, need to evaluate the reasons why the market is expected to suddenly discover the stock.

The bottom line is Investors will make better decisions if they focus on target prices, which convey more information for evaluating the potential risk/reward profile of a stock.