To calculate the future values of stocks, one must project how much a stock will rise or fall over a certain period of time. We set our Target Prices three to five years out and constantly update our thinking throughout our holding period, which often exceeds the initial time horizon. Initial recommendations are offered in The Prudent Speculator’s monthly newsletter, while Sale Alerts arrive via email the same day we transact.
Formulation
We formulate a Target Price using a wide range of factors, though there are building blocks that one can use to ‘short-cut’ the process.
One option is to use the compound annual growth rate (CAGR) formula, an estimate of future stock value using the following formula:
Future Value = Present Value * (1 + CAGR)^n
Future Values
To arrive at the Future Value, one plugs in today’s stock price for Present Value and n number of years for in the future (3 to 5, depending on your preference). Calculating the CAGR can be more complicated and can be specific to a particular company at a certain point in time or set broadly across a sector or country. Of course, distilling a multitude of factors, including those of the fundamental, economic and geopolitical varieties, into a single number is a tall order.
CAGR
Relying on a single number like a CAGR can have huge implications. For example, Company A sports a 5-year CAGR of 15% and a current market price of $165. Using the formula, we would expect Company A to grow to $314 in 5 years. In the event that we thought Company A couldn’t keep that high growth rate going, we might opt to use a 5% CAGR, which would result in a 5-year Future Value of $266. Simply trimming growth expectations from 15% to 10% caused the expected value of Company A to drop a whole $48 per share. As a result, we prefer to use a more detailed approach that is less sensitive to a single number.
Target Prices
Rather than rely on a single datapoint, we analyze and review a wide range of fundamental factors and do deep-dives into individual businesses, which we think helps us formulate fairer, well-supported Target Prices. We think factors are useful to investors of all types and we offer many of the datapoints we utilize in our newsletter Buy List, as well as the Target Prices workbook that is updated on the website twice per month.
Conclusion
While it can be enticing to use a formula like the one above and hold just a few stocks with lots of upside potential, we think it’s wiser to employ broad diversification in order to reduce single-stock exposure (avoid putting all the eggs in one basket).