Analysts make recommendations for different stocks based in part on expectations of the stock's projected price as compared to its current price. They use this future price estimate to calculate the stock's projected annual rate of return for investors. Projecting stock prices requires certain assumptions and works best with stable companies that have fairly predictable earnings performance each year.
1. Locate the company's historical earnings per share (EPS) for the previous five years. Fewer years of historical information works, but five years of information provides more valuable insight on the company's earnings stability.
2. Calculate the company's future earnings growth rate based on its historical growth. Calculate this using the compound annual growth formula. The equation is fairly simple, but requires the use of a financial calculator or spreadsheet formula. Divide the fifth year EPS of a company by the EPS from the first year. Then raise this result to the power of (one divided by the number of time periods), in this case, five years of EPS results. Subtract this result from one. For example, assume EPS in the fifth year is $3.20, and $2.80 in the first year. Divide $3.20 by $2.80 to get 1.14. Raise 1.14 to the power of (1/5) or .20, to get 1.03. Subtract this result from 1 to get .03, or a 3 percent historical compound annual growth rate.
3. Calculate the final stock price projection. Gather the company's price to earnings (P/E) ratio figures for the previous five years. The company's P/E ratio can have some variation over the years. Taking a conservative approach, choose the lowest P/E ratio, and multiply this number by the projected earnings per share. This provides an estimate of the stock's price in five years.
4. Interpret the results, and take into consideration any qualitative information regarding the company's future performance. The projected stock price is the result of many assumptions about earnings growth. Anything that impacts the company's revenues, such as anticipated seasonal slowing, could reduce earnings. Conversely, improved efficiencies that reduce costs could cause greater earnings improvements and reflect in the stock price.
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