How to Pick a Sell Target
January 30, 2018, 10:41 am
Stocks have been on a near non-stop rally since August despite rising interest rates. While earnings season has always impacted market direction, it is almost as if these last results from 2017 don’t really matter. 2018 is what actually counts, and Wall Street is even becoming more focused on what 2019 will hold.
As valuations rise, so have the buy limits and targets I set for my stocks as I adjust the prices based on 2019 earnings expectations. This might be a little aggressive, but it is necessary to put my targets in line with the way investors are thinking, which will put me on equal footing as I look for stocks that will outperform.
There’s a lot behind the scenes that goes into coming up with these targets, and I wanted to give you a special look behind the curtain today. Let’s start by breaking down the math.
You might find this hard to believe, but the calculations are actually the easy part. I take a reasonable earnings estimate and apply an appropriate multiple to generate a target, with the time of the target usually being the start of the 12-month holding period (for my longer-term investments) that the earnings estimate is based on. For example, my targets following this year will be a year-end price based on 2019 earnings estimates, although this can vary based on market conditions.
Determining the multiples that give me the target is a bit trickier. It is common practice among companies to give forward guidance for earnings, but I don’t think it’s smart to follow management’s guidance blindly so I always double check to make sure the numbers are realistic and see if there are any competitive or macroeconomic factors they may be missing.
Finding the proper multiple is a bit of an art form (I could write a whole book on it!), but it boils down to the overall market multiple, how quickly the company is growing and how long that growth can last (the higher and longer, the more elevated the multiple), the risk level of growth being interrupted due to economic or competitive reasons, the amount of capital the company employs to sustain the growth (less unnecessary investments, more free cash flow is better and the higher the multiple) and the strength of its balance sheet.
All that said, targets can change quickly based on what is happening to the company and the market as a whole, which is why I use them as a guide and why I’ll sometimes sell before the stock hits my target or hold for even higher prices.