We've received a lot of interest from members regarding how we go about generating our price targets and want to take a moment to discuss it in detail so that we can both increase transparency and help members determine their own targets.
The first thing to keep in mind is that determining a price target is about as much an art as it is a science. At the end of the day, a stock (or anything of value for that matter) is only worth what someone is willing to pay for it. Nowhere is this truer than in the stock market.
The second factor to keep in mind is that valuations are highly relative -- that is, it is nearly impossible to determine an appropriate price target without some context, be it the current market multiple (what we can assume an investor is willing to pay for your average, run-of the-mill stock), or more ideally, the current valuation of peers (comparable companies in the same industry).
Lastly, it is important to determine the appropriate valuation metric based on the company and/or security in question. The most common multiple is the price-to-earnings (P/E) multiple. However, some analysts also will focus price-to-cash flow (P/CF), enterprise value-to-EBITDA (EV/EBITDA), or, as we often call out with our financial positions (specifically Citigroup (C) ), price-to-tangible book value (P/TBV). The metric of choice is usually tied to the type of business. In the case of the banks, we view P/TBV as appropriate because banks have little in the way of physical assets and the TBV is what the bank theoretically would be worth in the event of liquidation. EV/EBITDA may be more appropriate for a business with a high amount of depreciation and/or amortization as it seeks to value the business based on continuing operations without penalizing it for natural and unavoidable depreciation of assets.
Now that we have that in mind, let's look at an example. We believe this to be the easiest way to illustrate the process of generating a price target. For this example, we will examine our $232 Raytheon Co. (RTN) price target, which based on current fiscal 2019 earnings estimates represents just over 20x earnings.
As we noted above, determining a price target is part art, part science. The first thing to take into account is the fundamentals -- that is, how is the company being valued now and what does it have going for it that rationally could cause it to be sold at a higher price in the future (or lower price in the case of a short sale).
So, in the case of Raytheon we can see that it trades at (based on its market price of $200 at the time of this write-up) roughly 19x future (next 12 months, or "NTM") earnings of $10.49 (total earnings estimates for the third quarter of 2018 to second quarter of 2019). This current valuation is our starting point. The next question is what will cause its shares to trade higher? Possibilities include multiple expansion, an increase in earnings, or some combination of the two.
In the case of multiple expansion, we simply could say that without any change in earnings estimates investors will pay up for defense stocks in the future based on our view that the "low threat" environment we are in due to progress with North Korea will fade as rhetoric in the Middle East heats up and the potential for conflict increases. These factors will lead investors to speculate about more sustained earnings power for defense contractors and thus will increase demand for defense stocks -- that is, investors simply will bid up these stocks despite no change in earnings estimates due to an increased threat environment and a desire to own names they believe stand to benefit.
In the case of higher earnings, the determined price target is largely based on an estimate of earnings growth, i.e. higher earnings in the future. As of this write-up, Raytheon's fiscal 2019 earnings are estimated to be roughly $11.64 per share (verses NTM EPS estimates of $10.49). If this number were to increase (say management raises guidance or simply surprises to the upside), then shares theoretically would push higher as investors simply apply the same multiple to the higher earnings. With this example, we can see that shares, in theory, should press higher as the company achieves higher earnings results; that is, a 19x P/E and EPS of $10.49 yields the price as of this write-up of about $200 a share. Taking the EPS number up to $11.64 (what we expect the company to achieve by the end of fiscal 2019), we reach a share price of $213, with no adjustment to our multiple.
Clearly, given our $232 target, which is based on the fiscal 2019 earnings estimates, we expect a combination of the two -- multiple expansion as well as earnings growth. The earnings growth estimate is easy enough to determine based on management guidance and sell side analyst estimates, which often are aggregated to yield a consensus number.
The preceding brings us to the question of what is a reasonable multiple to expect. Calling for a 50x P/E multiple certainly would be a bit ridiculous as we don't expect any major fundamental shift in operations that rapidly would accelerate growth between now and the end of fiscal 2019.
Here is where the subjective "art" side of price target analysis comes in. For starters, we already know that in the current market environment investors are willing to pay about 19x NTM earnings simply by dividing the current share price ($200) by earnings estimates for the next four quarters ($10.49).
Next, we attempt to factor in our industry outlook. As we know, defense spending is on the rise, a factor that will aid revenue and earnings growth for defense contractors such as Raytheon, and it is a significant reason why we believe the company ultimately will justify a higher multiple. Simple as it may sound, our bullish outlook causes us to believe that shares will be valued more highly.
You will recall that the brunt of our investment thesis is based largely on increase NATO activity, elevated tension in the Middle East, a rising defense budget in China and by Russia toting hypersonic missile capabilities for which there are currently no defenses. These factors are compounded by the potential for deterioration in North Korean negotiations.
Given this outlook, we reasonably can assume that the valuation (i.e., the P/E multiple) of a premier contractor such as Raytheon stands to increase. So, given this outlook, we believe that if investors are willing to pay 19x NTM today, they should be ready to spend about 20x earnings should our thesis play out as expected.
Why 20x, not 19.5x? Again, more art than science. However, we can make reasonable assumptions by analyzing peers and historical valuations. As we noted above, valuation multiples are relative; we would not value Raytheon based on the multiple of Netflix (NFLX) or Amazon (AMZN) . Looking at the historical P/E of several defense contractors, we can see the following:
So, we can clearly see that while our target multiple of 20x is above the five-year average, it is well within its past trading range. Combining this historic and peer evaluation with our bullish outlook on the industry and our belief that Raytheon deserves a premium in light of its highly in-demand Patriot missile defense system, we believe that should our thesis play out (that increased defense spending due to the factors outlined above will result in more business for Raytheon), investors will pay an above-average multiple for shares due to sustained earnings power. Moreover, given the trading range for the big four names noted above, we believe that while 20x is certainly bullish (we are bullish on the name, after all), it is not at all unreasonable, and if anything perhaps a bit conservative should all the factors in our thesis play out and North Korea prove not to be serious in its promise of denuclearization.
We hope this example helps to illustrate a little bit of what goes into determining an appropriate price target. And while the steps may differ somewhat depending on the valuation metric used, the idea is the same; determine an appropriate valuation metric (usually P/E), determine an appropriate multiple based on peer levels and historic results, and plug in your estimates. In this case, we chose the P/E metric, determined a tick over 20x to be appropriate given peer and historic levels (keep in mind estimates change constantly and have changed somewhat since our initiation of Raytheon, causing the price target in this example to differ by $1 to $2 from our stated $232 target), and simply plugged in consensus earnings estimates ($11.64) to yield a target of ~$232.
Dividend Yield Analysis
Another method we can analyze is valuing a company based on its dividend yield. Often, we state that we believe a base of support will come in due to a specific dividend yield or that we would purchase a company at a given yield.
This is usually more applicable to income-generating stocks with a steady dividend - usually found in mature industries as companies tend to increase payout as growth opportunities fades.
While the analysis is a bit more straightforward, the process of comparing companies to determine an appropriate yield is similar. We are essentially looking back to see at what level, historically, investors have found the yield appropriate given the growth or sustainability in sales and earnings. We will also look to compare the yield with other comparable companies. That said, we must also try to account for any changes in the business that may impact investor yield requirements.
Take the stock of PepsiCo (PEP) for example. It's safe to say PepsiCo is a mature, slower growing company with a healthy yield. In fact, PepsiCo is known as a "Dividend Aristocrat," a designation for those companies that have a 25+ year history of increasing annual payouts. While we certainly take the company's P/E based valuation into account, we also value the company based on its dividend yield (and safety, which we will discuss in more detail below). Doing a similar analysis as the one above, we see the following:
Keeping in mind that each of these companies have their own risk/reward profile and story, there are some things to take note of. One thing we can see immediately is that Starbucks' (SBUX) dividend yield is at a high, largely due to the fact that the company has recently experienced a slowdown in growth. As a result of less growth opportunities leading to dividend increases and investors selling shares (no longer willing to pay as high a growth premium), the stock has started to sport a higher dividend compared to historic levels. It is also worth pointing that despite Starbucks' yield pushing to new highs, the stock still pays out less than the Coca-Cola Co. (KO) and PEP as it has a materially higher growth rate, i.e. this is the perfect example of what we can expect to see when a growth starts to mature.
Back to the concept of valuation based on this metric, we can say that PEP and KO are at relatively attractive levels from the perspective of an income investor as both stocks are currently paying out above average yields - although we reiterate that changes in the company profile must be taken into account, i.e. the companies are becoming exceedingly more mature and thus should be expected to pay out more as growth becomes more difficult to come by. We can also say that based on its yield, PEP appears to be more or less fairly valued relative to its main competitor. Were the yield significantly higher than historic levels of that of competitors at the time (it could always be the case that investors simply demand a higher yield from the entire group due to a negative industry view), we would likely look to this as a potential buying opportunity.
In fact, in our June 8, 2018 Weekly Roundup, we stated, "we continue to view shares as undervalued at current levels. We believe shares, supported by a 3.7% dividend yield, are putting in a strong floor at around the $100 level." And while this was only part of our analysis, as we were also incorporating our industry view that beverages would inflect in the back half of 2018, it provided us with another valuable metric upon which our conviction in the name was bolstered.
We hope this helps in further breaking down how members can look to value stocks based on dividend payouts and believe this to be an especially good practice for those members with a large number of income generating stocks. It is also worth remembering that despite yields in percentage terms being impacted by changes in the stock price, the dollar payout should be expected to hold steady or improve barring any unforeseen negative financial updates. This is what we mean when we say we can "lock in a yield," if we buy shares of stock XYZ for $100, when the payout is $5 per share, we are "locking in" a 5% yield on our $100 investment ($5/$100). Should the stock double (and $5 payout hold constant), while the stated yield would drop to 2.5% ($5/$200), we would still be receiving $5 on our original $100 investment.
Lastly, when seeking to analyze dividend safety, it is always good to examine the amount of the dividend payout relative to net income and cash flow as this will provide a quick idea of how sustainable the payments are. Basically, a company cannot be expected to continue paying out more than it makes (net income) or takes in in the form of cash (cash flow). This is not the end-all-be-all of dividend safety analysis as management commentary is also key as there may be short-term pressure due to other uses of cash making these metrics appear more at risk than they may actually be (and management may also decide to take on debt simply to service payments should the net income or cash flow shortfall be temporary). However, it is always a good place to start as any dividend payout in excess of net income or cash flow should be an immediate red flag deserving of more attention.
Discounted Cash Flow Analysis
A slightly more complex type of analysis but one that is regularly used when valuing companies in various industries is discounted cash flow (DCF) analysis, which essentially attempts to value a company based on the present value of future cash flows (think free cash flow, cash flow from operations, dividends or something similar).
The two main items to consider are expected cash flows going forward and the required rate of return on the security in question.
This is best illustrated with an example. To keep it simple and focus more on the concept rather than an actual company valuation, we will assume we are looking at dividends, round numbers and made-up company, "XYZ." We will also assume that dividends grow at 10% per year for the next 5 years, the short-term growth rate, before immediately falling to a growth rate of 2% in perpetuity, the long-term growth rate, and that our required rate of return (r) is 8%. Ideally, we won't go out more than five years or so as these are all estimates and the further out we go, the less accurate we are likely to be as it becomes increasingly more difficult to forecast business conditions.
To start, let's assume that XYZ recently paid a dividend of $1, as this just occurred we will refer to it as D0. Given our stated shorter-term dividend growth rate (gS) of 10% for five years, we obtain the following:
D1 = $1.10, D2 = $1.21, D3 = $1.33, D4 = $1.46, D5 = $1.61
Additionally, with dividends expected to grow at 2% in perpetuity (gL), the next dividend (in six years) can be expected to be: D6 = $1.64
OK, so now that we have the next six dividend payments there are two additional steps we have to take to obtain the intrinsic value of the stock (assuming of course that all input estimates are accurate).
The first step, after estimating future cash flows, is to determine the intrinsic value of the stock at the end of year 5, when growth rates are expected to normalize, this is known as the "terminal value."
The second step is to discount the year 5 value and all dividends between then and now to present day.
For step one, we'll use what is known as the Gordon Growth Model (GGM) or in this case, the Dividend Discount Model (DDM). This is a very simple model that is designed to produce an intrinsic value in a given year using the following year's dividend (assumed to be paid out at the end of the year), a required rate of return and an expected perpetual growth rate of dividend payouts. The model is as follows:
V0 = D1/(r-g)
- V0 = Present value
- D1 = Next year's dividend
- r = required return
- g = growth rate.
Relating this to our example and goal of calculating the stock's intrinsic value at the end of year 5 (or the "terminal value") we can say that:
- V5 = D6/(r-gL) = $1.64/(.08 - .02) = $27.33
Finally, we discount the future stock price ($27.33) and all dividends until through this time (D1 to D5) to its present value (PV) using the required rate of return as follows:
- V0 (Today's Intrinsic Price) =
- [$1.10/(1.08)] + [$1.21/(1.08)2] + [$1.33/(1.08)3] + [$1.46/(1.08)4] + [$1.61/(1.08)5] + [$27.33/(1.08)5] = $23.88
Note: the denominator is raised to a value corresponding with the period because we must discount by the required return per year as illustrated below, i.e. if we require an 8% return every year, we must discount year 2 payments by (1.08)2 because we have to account for an 8% required return in year 1 and year 2.
This is the intrinsic value of the stock today, based on our growth expectations and required return.
While this is a bit more complex than the other valuation methodologies illustrated above, it does have the benefit of being exceedingly more granular as it looks to account for company cash flows rather than stock characteristics. And while we do not think that developing a DCF analysis is entirely necessary for every holding, having a high-level understanding of how these various estimates of cash flow, required return, and growth rates can impact a valuation model is helpful in gauging how generous or conservative an analyst may be with their valuation of specific companies. If, for example, you believe that the model in question is over-estimating cash flows, then clearly the price target is above your expectations. On the other hand, if you believe the required return to be too high (perhaps you expect risk-free rates to fall, leading to a lower required rate of return on equities) then the price target may be viewed as conservative given that the cash flows were discounted by too great a number. We hope this helps in understanding how DCF analysis is used by analysts and in better understanding analyst models in your own investment research
One last point we will note while on the topic of DCF analysis is that understanding this methodology can also help explain why rising interest rates can pressure equity prices.
To see this in action, let's leave all prior estimates the same but increase our required return to 10% (or 0.10) to illustrate that if (inherently safer) bond yields are on the rise, then we must require a higher rate of return on (inherently riskier) stocks. Before we even do the calculations, the result should be clear, by increasing the value of the denominator, we will ultimately decrease the ending value. Let's take a look:
First, we calculate the terminal value at the end of year 5 (V5):
V5 = $1.64/(.1 - .02) = $20.50
Next, we will discount the terminal value and all dividends using our new required rate of return of 10% and new terminal value:
[$1.10/(1.1)] + [$1.21/(1.1)2] + [$1.33/(1.1)3] + [$1.46/(1.1)4] + [$1.61/(1.1)5] + [$20.50/(1.1)5] = $17.73
With this, we can clearly see how any factor that increases an investor's required rate of return on stocks (in this case, higher bond yields) can impact the intrinsic value of a company today, even if there is no noticeable difference in a company's fundamentals or expected growth rates. Although we note that this is a simplistic view as higher rates make financing more expensive and thus ultimately impact expansion plans and other factors, including dividend growth rates and other cash flow metrics used in DCF analysis.
Sum of the Parts Analysis
Lastly, for another example of generating a price be sure to check out our sum-of-the-parts (SOTP) analysis on Allergan (AGN) . While events did not play out in line with our thesis, the process we went through, breaking the company down into individual segments, finding peer companies with which to compare those segments, valuing each segment based on its own earnings profile and finding the sum total, remains a basic template for SOTP analysis. The additional challenge with SOTP analysis is that it requires additional estimates.
While we realize there are countless other ways to analyze and value stocks, we hope this serves as a beginner's "crash course" to equity valuation, provides members with a better understanding of the methods we use when analyzing our own companies and helps in analyzing any other sources one may come across when analyzing a potential investment.