Tutorial: Setting Price Targets

This is an advanced topic.

Historical studies of leading growth stocks show that starting from a new bull market cycle that leading growth stocks breaking out of their first base often top 18-months to 2+ years later. In CANSLIM investing we typically pay zero attention to P/E when we buy a stock. However we do make use of it to help determine if a stock is in a possible topping zone. Typically a growth stock expands it first-stage breakout P/E by 130% before it finally tops. Often 130% works well but this is not an exact science, in 1997 the top 10-percentile leaders expanded P/E by 318%. 1997 was an exceptional year.

So the procedure is to first identify the first base breakout. We actually spend some time determining when institutions are entering and not just pick any base. Typically a breakout out of a base when the price is above $10 is in the institutional buying zone. 2009 was a strange year with institutional activity below this price. I look to see how many funds own a stock as well as inspect earnings and volume for obvious signs of institutional activity. Once I identify the instutional-quality first-stage breakout I determine the P/E at that time. I either have to find the prior 4-quarters of reported earnings per share to do this or use a shortcut of looking it up in an old financial newspaper. I keep all electronic copies of Inverstors Business Daily back to January 2003 for this purpose.

Next step is to access future expected earnings estimates 18-months to 2-years out from that 1st stage base breakout. The price target is computed by adding 130% to the first-stage base P/E and then multiplying that figure by the estimated future annual earnings to achieve the target topping zone price. Multiplying the P/E by 2.3 is the same as adding 130% to the P/E...

So lets use an example with Riverbed Technology, symbol RVBD...
The image below shows the chart and I have embedded the calculation on that chart. You may have to scroll your window to see the whole chart as it is pasted full size. I identified the first base breakout in March 2009. RVBD began its leadership at the same time that the general market signalled a new bull market. This chart shows RVBD price below $10 at this time but take note of the 2:1 split that happened in 2010, the price at the time was actually above $12. The computed price target was $39.10 using the then $0.85 forward EPS estimate in 2011. Since then the forward EPS estimate for 2011 has been increased to 0.89 which you can see on the left hand side of the chart in the data boxes for year 2011. I generally don't try to chase these numbers as they are modified but you can do so with a little bit of optimistic risk to your numbers.

On the chart I marked with a line and a box the approximate 39.10 price target. You can see that RVBD penetrated this line by about 14% and began what looks to me like a possible topping process with a 4-th stage base. It could be forming a head and shoulders pattern now although I find a potential flaw in that reading as the down volume on the right side of the head may not be adequate for a reliable read.

With knowledge of a future price target you can decide to have sticky fingers with a holding that you may have a substantial profit in with knowledge that the run up is probably not finished. Of course Mr. Market can and will have the final say on when the runup is done.

I annotate charts like this for my own use. Right now I have 596 charts marked up in this fashion so that I don't forget important details.
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First of all thanks for this excellent post. I am somewhat familiar with the CANSLIM approach but never was exposed to the idea of price projections within this discipline. I have my own "technical" approach to price targets but that is another story.
Question 1: When you made your projection in 2009, where analysts clever enough to project 2.5 times earnings increased?
Question 2: Are the estimates from IBES or another organization?
Question 3: If these estimates are a distribution of many analyst estimates, do you take into account the variability around the mean estimate when you make your price projection.

1. Was I clever enough to use the earnings projections at the time in 2009? Yes and no. I use the EPS projections at the time of the breakout of the first base if I am clever enough to do it at the right time. Often I notice a stock later in a sequence and I have no organized way to discover historical EPS projections so I use what I have. I am not sure but I suspect I calculated RVBD in late 2009 when the 2011 EPS estimate was 0.85 (it is currently 0.89)

2. The EPS estimates are from Investor's Business Daily (IBD). You can see the estimates on the chart I pasted. The chart came out small and hard to read. If you save it to your desktop and open it you can read the fine print.

3. Typically the EPS estimate equates to the mean of the estimates from other sources. I would have no problem uising the mean estimate from YAHOO Finance for example.

Lastly this is not a sell rule, just an indication to pay closer attention to your real sell rules or perhaps passing one up if it appears that it may have already reached target. In the latter case my watchlist should not be full of stocks with limited upside potential. I am finding this to be the case right now as I try to prepare a watchlist. Many-many stocks seem to have fulfilled their upside potential.

Great post.

Does the N in CANSLIM-- either due to internal forces such as occurred at Apple in the past decade or due to exogenous ones such as QE -- alter your projections and if so can you quantify how?

Thanx in advance.

Does QE effect the price target calculations?
Not so far, but then we are not really done with QE yet. Instead we have seen a bit of rotation into other issues. Many stocks have neared or have hit their price target since the 2009 lows. Most of them look like they have topped with late-stage bases but with QE I don't rule out anything. The fact that many leading stocks look to have finished their run is a bearish situation in my opinion as we stare into a possible rally this week.

One point I did not stress before is that this process is used for institutional quality stocks only. CANSLIM methods don't work well with cheap and thinly traded stocks and stocks with questionionable earnings.

Hi Mike,

Thanks for sharing all of your knowledge, which is very appreciated.

Can you elaborate on some of the ways you use to determine "fixed stars" versus "comets"?

By fixed stars, I am referring to stocks like ISRG, DECK, AAPL, BIDU, CMG, GMCR, etc.,

By comets, I am referring to stocks like TASR, STEC, TIE, CROX, etc.,

In other words, what types of criteria might be utilized to determine whether a growth stock has staying power and the possibility of minting profits with great consistency versus a stock that simply undergoes a brilliant rally followed by a slow and painful drift to the dustbins of the market?

When viewing the chart of ISRG, the 2006 "top" was merely the start of a long consolidation before another major breakout in early 2007.

Since CANSLIM focuses on 6-9 month rallies, do you simply monitor and track former leaders to determine a reset of the base count, whereby another significant move could take place?

I ask because I at one point held GMCR and BIDU from standard CANSLIM buypoints, but did not possess the experience to determine some of the characteristics that set these companies apart, which would have allowed me to hold.

I am curious if you can provide insight as to how you may handle "Big Stocks," and some criteria that is useful in making such a judgment.

Best,

Eric

[QUOTE=ericoleman;13023]Hi Mike,

Thanks for sharing all of your knowledge, which is very appreciated.

Can you elaborate on some of the ways you use to determine "fixed stars" versus "comets"?

By fixed stars, I am referring to stocks like ISRG, DECK, AAPL, BIDU, CMG, GMCR, etc.,

By comets, I am referring to stocks like TASR, STEC, TIE, CROX, etc.,

In other words, what types of criteria might be utilized to determine whether a growth stock has staying power and the possibility of minting profits with great consistency versus a stock that simply undergoes a brilliant rally followed by a slow and painful drift to the dustbins of the market?

When viewing the chart of ISRG, the 2006 "top" was merely the start of a long consolidation before another major breakout in early 2007.

Since CANSLIM focuses on 6-9 month rallies, do you simply monitor and track former leaders to determine a reset of the base count, whereby another significant move could take place?

I ask because I at one point held GMCR and BIDU from standard CANSLIM buypoints, but did not possess the experience to determine some of the characteristics that set these companies apart, which would have allowed me to hold.

I am curious if you can provide insight as to how you may handle "Big Stocks," and some criteria that is useful in making such a judgment.

Best,

Eric[/QUOTE]

Eric, you are asking a good question and I like your comets and stars terminology. Your question is the most important question in CANSLIM investing. Bill O'Neil talks to his internal poerfolio managers about the Big Stock concept. This would be synonomous with your "stars" perhaps. Bill is looking for stocks with staying power, stocks that he can pyramid into, stocks that he might eventually have 100% of his entire porfolio in just one stock on full margin. This could be a billion dollars invested in a single stock. Bill then has the same problem that institutions have, he can't move in and out quickly that much money.

Bill will buy the Crox's and the like but I suspect his time horizon is different for the comets and he may not be able to get all the way in on one of these. Once Bill has identified the BIG STOCK he will get focused.

So Bill looks for institutional quality stocks. Three factors stick out: The first is liquidity or how many dollars are traded each day on average. Large institutions can not trade thinly traded stocks. So one parameter is to compute liquidity by multiplying 50-day average volume by price. Above $40 million traded per day is guaranteed institutional territory. Maybe you can shade that down to $20 million per day at times. The second parameter is to check which institutions own the stock. Quality institutions owning a stock like PCLN for example tells you a lot, particularly if it is one of their top 10 or 12 holdings. Big institutions can not turn on a dime. When they enter a positions they plan to own it for 18 months or longer. Institutions provide stability and give you the confidence that you are in a star and not a comet. I am giving you a list of high quality mutual funds below. These are the funds O'Neil uses to check his own stock picks. His list has probaly changed a bit since I obtained this list but it won't matter much. Essentially these are the funds that have some good stock pickers that might overlap with CANSLIM-style picks. I use this list and I also know that Ken Heebner for example tends to pick well in a resource constrained market like we had in 2007 when oil and fertilizer-based stocks were doing so well. He is not so hot in a technology driven market. So I try to learn something about fund manager style. Over time this list gets stale and the way for us to refresh it is to visit the IBD page where they show the mutual fund index, page B6 in Monday's IBD (How's the Market?). In the header of the IBD Mutual Fund Index chart are 20 quality mutual funds that have been selected by hand at IBD to make up this index. By the way you can use Morningstar and may other services to inpect porfolios of these mutual funds. Vinik Asset Management is different though, it is a very large hedge fund. Jeffery Vinik's porfolio can be found at [url]www.nasdaq.co[/url]. Look under quotes and research and then Institutional holdings. In the search box search for Vinik and you will be there. The third paramater is earnings: big stable earnings growth. In a prior post I shared the powerpoint file on the nine-box matrix of stocks. The big stocks will tend to be in boxes 1, 2, 4, 5, and 7.


High Quality Mutual Funds
Use this list as a means to determine institutional sponsorship by a fund manager that normally picks good stocks.
TWGTX American Century Heritage Gift and Trust Jim Stower
ACRNX Columbia Acorn Fund
CMTRX Columbia Marisco 21st Century Fund
FBALX Fidelity Balanced Fund
CGMFX CGM Focus Fund Ken Heebner
LOMMX CGM Mutual Ken Heebner
FCNTX Fidelity Contrafund Will Danoff
FMAGX Fidelity Magellan Fund
FOCPX Fidelity OTC Portfolio
FPPTX FPA Capital Fund
HFCGX Hennesey Cornerstone Growth Fund
JAVLX Janus 20
LMOPX Legg Mason Opportunity Trust Bill Milleri
RSPFX RS Partners Fund
PRNHX T Rowe Price New Horizons Fund
Vinick Asset Management LP Jeff Vinick
WGROX Wasatch Core Growth Fund

[QUOTE=mscott;13024]In a prior post I shared the powerpoint file on the nine-box matrix of stocks. [/QUOTE]

Mike,
I think I missed this. Could you point me to the post?

Thanks.

P.S. Very interesting stuff! I'm enjoying your lessons and find the CANSLIM methodology quite interesting.

[QUOTE=aly;13025]Mike,
I think I missed this. Could you point me to the post?

Thanks.

P.S. Very interesting stuff! I'm enjoying your lessons and find the CANSLIM methodology quite interesting.[/QUOTE]

Just look back a couple of posts to the topic called Value of Earnings. In that thread were two attached files, a powerpoint explaining the analysis I did and a spreadsheet of the underlying data.

Mike Scott
Tarzana, CA

Mike,

Thank you for the detailed response. I've heard the "stars" analogy used before, so I can't take credit for that. I greatly appreciate your feedback on what appears to be the crux of a method like CANSLIM - drilling down and concentrating on the very best candidates. I believe EV is a useful tool in analyzing such opportunities.

Looking forward to more lessons.

Best

Eric