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Yes! You can keep it!
Then why do people say that I am selling it as it has reached its target price?
Because most of us don’t understand the concept of target prices.
So lets discuss what does it really mean when a stock reaches its target price.
What is a target price?
When the expected returns from a stock matches the required return from that stock, then it reaches its target price.
Expected return = Required Rate of Return
This means that, from now on (i.e. after the stock reaches it target price) you should only expect return equal to the required rate.
In other words no extra return should be expected from this stock.
See whenever we invest in the stock we can expect / we can get two types of return from it.
- The normal required rate of return = the minimum return we need to invest in the stock market and
- Extra return when the stock is trading below is target price or fair value.
What is our required rate of return?
- If the interest rate is 12%
- Additional risk we need over and above to invest in any stock is 8%
- The extra volatility in the stock is 1 (beta, it is as volatile as the overall stock market)
- Then the required rate of return from the stock is 20%
This means, no matter what, we at least need 20% per year from this stock.
What can be our extra return?
If and when the stock is trading below its target price or the fair value, that difference is the extra return.
What this means is, the stock should be trading at Rs100 but since its trading at Rs50, we will get 100% return and when it reaches Rs100, we will start to get only the required rate of return.
The concept in play
Now lets say that a brokers gives you a target price of Rs100/sh and the stock is trading at Rs50 - how much return can we expect from the stock?
Most of us will say its 100%
Actually thats not completely correct.
If this stock reaches it target price, then we will enjoy the extra 100% return over and above the 20% return it will continue to give us if it stays at Rs100/sh for the next many many years.
Revision
This means that any stock which is trading below its target price is offering two returns:
- The normal 20% return, without which we will never invest in that company plus
- The misplacing return i.e. for the stock to keep giving 20% it should be at Rs100 but since its at Rs50, we may enjoy 50% return.
All in all, if a stock reaches its target price, you can still hold it if you want market type returns coming from the stock which in out case is 20%.
When you sell it, it means that you wanted extra returns (more than 20%) and some other stock has it so you are selling it.
The Question
But you have seen the stock surpass its target price right?
You might also have noticed that the broker keeps changing and moving its target price higher.
Why does that happen?
To understand that you need to understand what goes into a target price and from there you can understand the problems of it.
Not all the target prices are Final
If you have read the above passage carefully you would have realized that the target prices have a few components which may change!
- Growth in Cashflows
- Reminder: Where does the earnings growth come from?
- Sales growth leading to earnings growth (most of the companies we see)
- Margin growth leading to earnings growth (Pharma type earnings growth)
- Cut in costs leading to earnings growth (debt or finance cost, firing people etc)
- Rate of Risk
- Volatility of the stock vs the index
Now is it possible that these things change after the broker has issued a target price?
Yes - 100%
All of these can change.
For instance:
- The company launches a new product and the sales starts to grow faster than the broker assumed - the target price will change
- Company pays off debt after selling some side asset - earnings can grow and hence the target price will change
- Interest rates come down and hence we don’t need a minimum 20% from the stock market means the target price will change
- The stock becomes more stable vs the overall market and hence we are not carrying extra risk vs the market - this means we require less return from it vs a very volatile stock which means the target price will change
You see the issue?
If any of these changes, the target price changes.
What do we understand from this?
This means that I can comfortably say that:
- Any target price calculated when the interest rates are higher, are bound to go up when the interest rates fall
- If the analyst thinks that the growth is faster than what he assumed or can be higher in the future, the target prices can change
Most importantly, it says that if you are picking stocks, never ever get fixated on the target price by a research report and look at his assumptions, like the interest rates, the growth in earnings, the volatility of the stock.
You might not find them in short report, but you will definitely find it in longer, multi pager reports.
Read them and read them properly.
Bonus: The cyclical stocks’ target prices can go up much faster than an average dividend or long growth stock
Why is that so?
Think in cycles (I always say this right?).
Think in chain of events.
Example of a simple chain of events
- Broker calculates a target price of a cement company when the interest rate is 20% - required rate of return from a cyclical stock can be 29.8% (Risk premium of 8% and Beta of 1.2)
- The target price is Rs100 and the stock is trading at Rs50 - he says that the upside can be 100%
- Something happens and the stock reaches to its target price of Rs100
- You are thinking to sell now but….
- The interest rates starts to fall due to which he think that growth will be higher than he assumed before, the finance cost will be less than he assumed and the margins will higher
- One month after that, he issues a new target price of Rs200
- Now there is another upside of 100%
- Everyone is making a killer return but then the government forgets that the growth we are getting is through borrowed money
- Now the brokers’ target price for the same stock has reached Rs300
- The rupee starts to depreciates when deficits run high, or a change in global economics or we stop getting new debt
- Interest rates starts to creep up
- The stock is trading at Rs200 but it starts to fall
- Seeing all these changes the brokers adjusts his assumptions and changes the target price to Rs150!
Did you get the idea?
One event triggered so many new things which changed the target prices.
Conclusion: Target Price is not a Sell Signal - Its a price to start rethinking about the stock
Whenever you see a stock reaching its target price think about variables or assumptions.
The broker has calculated the target prices on a these assumptions.
When the assumption change, the target price changes.
So target prices will often go wrong at peak of cycles - be it all-time high interest rates and they have started to fall or low interest rates starting to go higher.
And even when these macro things are not playing out, you can still hold it if you are ok with a market type return.
Lamba thana? Abhi to me Target Price vs Intrinsic value per gaya bhi nahi hu!
But was it worth the read?
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