When you invest in stocks, it’s always smart to do some research. One of the things you’ll run across in that research is something called the “target price.” That figure is usually far away from the current price. Don’t let this confuse you. Once you understand what a target price is, you can actually use it to help you decide whether or not to invest in a stock.
Target Price Advantage
A target price is an estimate of where an analyst thinks a stock will go. An analyst will typically set a one-year target price. Calculating a target price can be done a couple of ways. One is by using fundamentals of the company to guess how far up the stock could go based on current earnings and profits. The other way is to use the technical analysis based on how the stock looks. Technical traders look for patterns to suggest how far a stock could rise. If analysts are right about a target price, the advantage to you is that you can pick stocks whose current price is much lower than the target price and watch it to see if it rises to meet analysts’ expectations.
Target Price Disadvantage
The analysts could be wrong. No one has a crystal ball on Wall Street. A target price is merely an educated guess on where the price could go, not where it will go. If some news comes out suggesting that the company is in trouble, the target price could become unreasonable. Assuming that your stock will always reach the target price is a dangerous investment practice.
Advantage of Starting from the Actual Price
According to Efficient Market Theory, the stock price reflects all the information that’s available to investors on any given day. Under this theory, you treat the actual price as a consensus reached by investors. Assuming that most of those investors know what they’re doing, the price is a fair valuation of the stock based on what’s known about it. This gives you a reliable starting place for comparing the stock to its target price, if Efficient Market Theory is true.
Disadvantage of Starting from the Actual Price
The actual price of a stock is simply the last price it traded for. That means the last two traders agreed on price and it changed hands. Investors such as Warren Buffett do not consider the markets efficient so, according to that line of thinking, the actual price may not be a fair price. In addition, if you assume there’s a straight line up from the actual price to the target price, you could be in for a surprise. There’s nothing that prevents a stock from dipping in value even if it will eventually rise to a target price. That dip could last days, weeks, months or years.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.