How To Calculate The Target Price Of Your Investment?
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When it comes to investing, one key thing to have at the back of your mind is the target price of your investments.
In this video, I will share with you how I calculate the target price and the expected returns of my investments using a modified form of the relative valuation model.
Without further ado, let’s get started.
Relative Valuation Model Explained
The main question we are trying to solve with the financial modelling is the question of:
“What is the likely target price of the investment at the end of x number of years”
To answer the question, I will forecast and stress-test two aspects of any given investment.
The first is the assumed earnings per share growth rate and the second is the future valuation multiple that the investment might be trading in.
For those who are unfamiliar with either of these, earnings per share refer to how much money an investment makes per unit of share of the investment while valuation multiple essentially reflects the willingness of investors to pay for a given investment.
The valuation multiple that I am using for the modelling is the Price to Earnings Ratio which measures the investor’s willingness to pay for a dollar of earning per share of the investment.
In essence, I’m trying to forecast the target price assuming that the earnings will grow at different percentages while keeping the investor’s willingness to pay constant or...
Forecast the target price given different degrees of investors’ willingness to pay while assuming that the earnings will grow at a specific percentage.
Now, with all forecasting models, the biggest challenge is to ensure that your assumptions remain reasonable and realistic to ensure that your forecast's accuracy remains high, which brings me to my next point.
How to keep your assumptions reasonable?
To keep my forecasting assumption reasonable, I will always reference the long-term average, which spans over a 20-year investment horizon - for both the earnings per share growth rate and valuation multiple.
From there, I will make judgements as to whether the past performances are sustainable moving forward or should I revise the figures upwards or downwards.
For example, if the compounded annual growth rate of the earnings per share over a 20–22-year period is 5-6%, the question you got to ask yourself is if it is reasonable to assume that the earnings growth will exceed 5-6% or should we revise our expectations downwards.
As a rule of thumb, for developed markets like the US and Europe, I will always revise the long-term growth estimates downward as it is not reasonable for them to grow faster than before just as it is not reasonable to expect an adult to grow faster than a teenager.
For developing markets, to be conservative, I will keep the growth estimates to be either the same or slightly lower than the long-term average so as not to overestimate its future growth rate.
With regards to valuation multiple, I will forecast three different scenarios to simulate an overvalued, fairly valued and undervalued investment market environment.
Once again, the main reference that I will refer to is the behaviour of the investment multiple over a long-term period.
As a rule of thumb, I will use the long-term average to simulate a fairly valued environment and add a sufficient buffer above and below the long-term average to simulate an overvalued and undervalued market situation.
Once you have the forecasted figures what’s left is to calculate the target price which brings me to the next point.
Deriving the target price & expected return
Given that we had calculated the forecasted future earnings and expected price-to-earnings multiple, to derive the target price, all we have to do is just reverse engineer the price-to-earnings formula to calculate the target price.
What I like to do is to come out with a range of forecasted earnings per share and reverse calculate the target price based on the different valuation multiple environments.
Doing so will allow us to have a gauge of what the likely target prices would be given the different scenarios.
From there, we can then reverse calculate the annualized expected return based on the target price over a specific investment duration. This will help us gain better clarity as to what the expected return of your investment would be if you were to invest today given the different scenarios.
With that quantitative information in mind, the next step is to make sense of the numbers by integrating them with your qualitative analysis. From there you will be able to derive whether it is a good time or good price to invest or divest.
Having a financial model that you can rely on will enable you to make decisions based on facts and figures instead of irrational emotions and it will drastically improve the quality of your investment decision and hence improve your investment performance.
If you do not know how to get started with your investments or if you do not have the time to manage your investments, you can check out what I do here to see how you can benefit from my investment planning services and reach out to me directly.
Daniel is a Licensed Independent Financial Consultant with MAS and a certified Associate Wealth Planner that provides:
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This article is meant to be the opinion of the author
This article is for information purposes only
This article should not be seen as financial advice
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