CHICAGO, Dec. 6, 2012 /PRNewswire/ -- Stocks in this week's article include: American Railcar Industries, Inc. (NASDAQ: ARII), Ethan Allen Interiors Inc. (NYSE: ETH), Krispy Kreme Doughnuts, Inc. (NYSE: KKD), Piper Jaffray Companies (NYSE: PJC) and Sinclair Broadcast Group Inc. (NASDAQ: SBGI). Kevin Matras goes over how to calculate a stock's price target and how to find stocks currently trading below them.
Screen of the Week written by Kevin Matras of Zacks Investment Research:
Regardless of what you think may or may not happen to the market, everyone would like to have a better understanding of what their stock's potential price target is. And that's what we're going to talk about today.
You can do this by using either technicals or fundamentals. Today, I'm going to focus on the fundamentals. And we're going to use the P/E ratio to calculate it.
Many people use P/E ratios to determine a company's perceived under or overvaluation. But you can also use the P/E ratio to determine a stock's upside and downside price targets. The two most common P/E ratios used are the (1) P/Es using the Trailing 12 months (or 4 quarters) of earnings and (2) P/Es using the F1 (or Current Fiscal Year) Estimates.
The calculation for the P/E ratio is simply price divided by earnings. For example: if a stock's price is $30 and its earnings are $1.25, its P/E would be 24. If that stock's earnings rose to $2.00, the P/E would now be lower at 15. ($30 price / $2.00 earnings = 15 P/E) And the most logical conclusion would be to see the stock's price rise until its most recent multiple (or P/E ratio) of 24 was hit again.
Why is this so 'logical'? Because if people had just been willing to pay 24 times earnings, they probably will again if they believe the company's earnings will continue to improve. And in an environment where P/Es are increasing, they might be willing to pay even more.
You'll also find that most of the time a stock's P/E ratio using EPS actuals is higher than its P/E ratio using its forward estimates. That's because of the uncertainty regarding the projected earnings vs. the certainty of actual earnings. As the company continues to report (and meet its projections), the forward P/E ratio typically increases, which means the stock price increases as the earnings projections are coming to fruition.
And as more optimism grows over future earnings growth, you may see the P/E ratio grow even more, getting even higher than its previous multiple. So, the calculation to figure out your stock's price target is…
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