Defining Price Targets

I'm finally settled into my new digs here at TSC where I'll be applying my newly acquired MBA skills (oxymoron alert) under the mantle of "project manager."

Fear not, loyal readers and financial aficionados (all five of you). I'll also be continuing at the helm of Fundamental Questions, doing my best to steer you clear of the rocky shoals of investment confusion. Please do your part by sending in your queries to my new crow's nest at TSC central with the stunning view of the Trinity Church cemetery (home of more notable writers like Alexander Hamilton). Off we go.

The Making of a Price Target

I always hear about price targets placed on individual stocks. Andrew, my question is what numerical figures are being used to get this figure? Thanks,

Alan Wiesner

Alan,

Basically, analysts just put numbers on tiny bits of paper and pull them out of a big sombrero while shooting tequila and dancing the merengue. Well, not really. But the process would probably be just as accurate.

The academics tout a host of valuation techniques from the venerable dividend discount model to leading edge EVA as viable means of determining a stock's intrinsic value in the marketplace. The idea is that if you find out what a stock should be worth based on hard analysis rather than what a stock is actually worth as a function of supply and demand, then you'll be able to predict price moves as rational investors equate market price with intrinsic value over time.

In actual practice, price targets are usually driven by earnings forecasts and an assumed price multiple. The way it works is as follows.

Based on exhaustive industry research and company interviews, Anna Lyst, our faux CFA, feels that Intel (INTC) is primed to earn $4.70 per share in 1999. She also thinks that the firm's future growth prospects justify an ongoing P/E ratio of 32. So, she just multiplies $4.70 by 32 and, voila, out pops an instant year-end price target of $150 per share.

Coming up with a reasonable estimate of earnings and P/E isn't exactly child's play, but once you've got the figures in hand, defining a price target is a piece of cake.

Keep Your Clothes On, Perry

What is the advantage of selling naked puts? I own stocks that I wrote covered calls on. Can I sell naked puts at or over the strike price of my covered calls to increase/hedge my position?

Perry Wander

Perry,

Whoa there! Better keep your clothes on and review your option basics before streaking off down Naked Put Lane.

Any time you sell a put, you're agreeing to buy stock from the option buyer at a specified price upon execution. The buyer is betting the stock's going to plummet so he can "put" you his shares at a price way higher than the market value and make a killing. You're betting the stock will hold its own so you can pocket the measly little premium you got for selling the option in the first place. Selling a naked put simply means that you have no corresponding short position in the underlying stock to offset losses if the stock tanks.

So let's say you decide to sell 100 Philip Morris (MO) April 35 puts at 5/16. Day one, you pocket $3,125 in cash (minus commissions). As long as MO stays above 35 by expiration, you get to keep it all. So far so good. Next thing you know, China outlaws smoking and the Marlboro Man is being burned in effigy in the middle of Tianamen Square. MO drops to $25 overnight and suddenly you're on the hook for $100,000.

Bottom line: Lots of risk, limited upside.

As for your strategy of selling calls and puts simultaneously against a stock you already own, I'm dumbfounded. What on earth could you possibly hope to accomplish besides collecting a small premium on each option if the stock doesn't budge? If the shares go up, your stock gets called away and you miss out on the upside. If it takes a nose dive, you suddenly own twice as much of a losing proposition. Any of you arb types out there, please let me know if there's some kind of sophisticated logic here that I'm missing.

In the meantime, sounds like it may be a good time to revisit Dan Colarusso's options primer before concocting any more sure-fire strategies.

Road Kill

Hi, Andrew,

I ran across something the other day that didn't make sense. Golden Books Family Entertainment (GBFE) showed up on the biggest percentage loser list the other day so I took a look. What caught my eye was its showing (in Yahoo!'s profiles) of a book value of minus $7.10. I don't have a clue how a minus book value could exist. Do you? Thanks in advance.

Tom Winberry

Tom,

Pretty simple really. Golden Books Family Entertainment is road kill on the corporate highway. Remember that book value is simply the amount left over if all assets are sold at their accounting value and all debts are paid off. In general, it represents the value that management has created by prudent deployment of assets.

In GBFE's case, liabilities exceed assets by $7.10 a share and it has no money to pay off its lenders. In short, it has done an outstanding job of destroying shareholder wealth. Unless the company can pull a miraculous reorg out of thin air, it looks like the stock's going to zero and the bondholders are going to eat a big loss as well.

That's it for this week. Keep sending those questions -- and include your full name.

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