If you think that a target price means the price at which you sell, you're wrong. Target prices are used as the next milestone for measurement as a company grows. To understand how to use target prices, you should first understand how they are created.

The logic behind creating a target price is not complicated. Choosing the right numbers to plug into the logic is a little trickier.

Target prices are derived in the following way. (This example uses a Price/Sales projection as the basis of the target price.)

• Select a time frame based on how far into the future revenues can reasonably be projected.
• Project future revenues based upon past trends and certain assumptions.
• Make an assumption of the market multiple, in this example, a Price/Sales ratio, that can reasonably be expected. (Generally derived from comparisons of how the market values other companies that have already reached the projected revenue level, at approximately the same rate of growth, in the same industry - if any such comparable companies can be found.)
• Using that Price/Sales ratio, calculate the market capitalization of the company at the projected time. (Multiple the Price/sales ratio by the projected trailing 12 month revenues.)
• Calculate the expected number of shares at the projected time. (Generally just an extrapolation of current trends in the number of shares.)
• Divide the projected market capitalization by the expected number of shares.
• This gives you the target price per share.

It isn't any more complicated than that.

The trick, of course, is making a reasonable projection of revenues, and choosing the right comparable multiples.

That is where certain assumptions are made, which must then be very carefully measured against how the company actually performs.

For all target prices, the longer the time frame, the less reliable the assumptions become. After all, who knows what multiples the market is willing to give three months from now, much less two years from now?

Note: the above example uses revenue projection as the basis of a target price. Other parameters can be used, such as earnings, or EBITDA. Some target prices are derived from multiple parameter projections. Revenue is the most common metric for Internet and new economy stocks, while earnings are more commonly used for old economy stocks.

So what happens when the stock reaches the target price?

In an ideal world, all of the assumptions made about revenue growth and comparable multiples come true, just as expected, in the time frame projected.

That's what reaching the target price means: the previously made assumptions were valid!

Why would you sell a stock which reaches your target price on precisely the day you projected it would. It means that everything you believe about the company is not only accurate, but predictable!

If anything, reaching a target price should increase your confidence in the stock, not decrease it so much that the stock should be sold.

So if target prices aren't sell signals, what are?

For investments made on a premise (a theory about why the company will grow), you shouldn't sell until the premise has been either fulfilled, or proven to be wrong. Reaching a target only confirms that your assumptions about a premise are correct.

If something happens that challenges your belief in the assumptions on which the target price projection was made, that event may be a sell signal. If it is an earnings shortfall announcement, the stock may drop overnight, with little chance to react. If it is an event in some other company, such as a sudden shift in the market multiples, that may be a signal that allows you to exit gracefully.

Changes in the assumptions behind a target price are reasons to sell, not attainment of a target price.

A not uncommon occurrence is that a target price is announced by a sell-side analyst and the stock races up to, or even exceeds, that level in a matter of weeks.

It seems as if the market sometimes decides that the target price is a measure of what the stock is worth, and views any purchase below the target price as cheap. This is a difficult situation, and it tests your level of faith in your assumptions.

On the one hand, you can view the situation as getting paid without taking the risk. Or you can view it as the market putting even more faith in the underlying assumptions.

In most cases, for long-term investors, hitting a target early is a cause for comfort. It provides a cushion of profit as the assumptions behind a target get tested.

Sometimes you see an upgrade issued, by a sell-side analyst, with a target price below the current price. How can that be?

This occurs when an analyst reexamines one of the assumptions underlying a previous target projection. It may be that the assumption was not bold enough.

As the revenue projection assumptions become stronger, the analyst issues an upgrade without waiting to make a new, fully calculated projection of the revenue. The upgrade is then issued with the previous target.

This causes confusion among many, because it looks like the analyst is projecting a stock decline, but is issuing an upgrade. That is not the case.

When an upgrade is issued with a previous target, a new target is usually calculated within twenty-four hours. In the meantime, investors generally ignore the old target. It is more an indication that the stock has arrived at its current target, and that a new set of assumptions is in the process of being formulated.

On high mountain trails, cairns, pyramid piles of rocks, are used to mark the way and point to where the trail leads. They are particularly valuable when the trail covers bare rock, where no path is visible.

Cairns are usually placed within visual sight of each other. You may not be able to see the entire trail ahead, only the next cairn.

Target prices are really just cairns for the investor. They indicate how far ahead a reasonable analysis can be seen. The best targets, just like cairns, are only placed as far ahead as the next major decision point.

And when you get to that cairn, you start looking for the next cairn. And when your stock reaches its target price, you start looking for the next set of assumptions that can be reasonably projected.

The best stocks, like the best trails, will have many cairns along the path, pointing out the way ahead.

Robert V. Green