The Tricky Business of Setting Targets

How, exactly, does an analyst set a price target for a stock?

Consider a recent report from analyst David Adelman at Morgan Stanley Dean Witter, who has set a 12-month price target of $56 for shares of tobacco giant Philip Morris.

That would be a huge gain from the stock’s current price of $24.25. How will it get to $56?

Despite the tobacco industry’s ongoing legal battles, Adelman said, Philip Morris still should earn $3.70 a share this year.

So a “fair” price for the stock by the end of this year, Adelman said, would be about 15 times 2000 earnings per share, or roughly $56.

Currently, the stock trades for less than seven times the 2000 earnings-per-share estimate. That means that inherent in Adelman’s price target is the expectation that investors will double the price-to-earnings ratio they’re willing to pay for the stock.

Adelman is betting that investors’ “litigation angst” will fade significantly over the coming year. If it does, he figures Philip Morris stock should trade at a price-to-earnings multiple that would be 40% less than the P/E for the market overall (as measured by the Standard & Poor’s 500 index).

Like many analysts setting price targets, Adelman relies on history: Philip Morris stock, he noted, “has traditionally been at a 20% to 40% discount to the S&P; 500 [in terms of P/E].” That discount has been closer to 40% when investors have been extremely concerned about tobacco litigation, and closer to 20% when concerns have eased.

Today’s Philip Morris P/E discount is far below the historical range. So Adelman, in coming up with a price target, is largely betting that the stock just returns to the low end of normal in terms of valuation--still a high-risk bet, all things considered.