Target (TGT) is one of the largest retail specialists, although it is by no means the biggest (WMT has a market cap 6 times bigger than Target’s). Its TTM P/E ratio remained in the teens for most of the last few years, rising steadily in 2014 until it spiked over 20 in the middle of 2014 on the expectations of future growth. It has spiked again and is around the 30 point after a massive quarter in which it crushed earnings expectations.
Last quarter, its revenue growth of 2.7% was a strong acceleration from the previous quarter, but its earnings beat by 7 cents, far above expectations as sluggish comparable store sales at WMT (0.5%) set low expectations. Target’s 1.2% gain and a 1.6% average transaction price increase impressed investors, as did its full-year EPS guidance of $3.15-$3.25.
A quick tabulation of the last two years’ revenue and EPS shows that TGT is seeing mostly steady revenue growth in the 1.8% range if we exclude as anomalous the fourth quarter of 2013 (it’s 1.01% without).
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With that in mind, we can then project the company’s EPS and revenue growth in the future, which we can then use to establish a price target for a particular time horizon. The trick here is in our assumptions; costs have been rising for Target for a few reasons, so we need to decide if the decline in EPS was temporary or permanent. Since 3Q14 showed a reversal to the trend, we might want to decide that the EPS growth has turned slightly positive. We may also want to assume that revenue growth of 1.8% is modest but reasonable considering the improving U.S. economy and Target’s strength in its sector.
If we accept these assumptions, it becomes simple math to project growth over the next few years:
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Now we can easily put a price target on this stock. Its current P/E ratio is 19.91, and assuming it keeps that ratio throughout the next few years, its price should rise to hit 78.2 in 2019, a modest but healthy rise from current levels.
Of course, an investor will not just buy Target today because they believe there will be a steady revenue and EPS growth; they expect TGT to outperform for one reason or another. The key here is valuing the meaning of the EPS decline in early 2014; if this was an anomaly, we should project steady EPS growth from 2013’s levels into the future. When we do that, we get the following yearly price targets:
Now we can see that the market’s current price ($71.15) is undervalued by over 12% of its true value, making it a buy. This is how financial modeling can make investors bullish on a stock.
Of course, there are risk factors; we are assuming steady growth of revs and earnings, but hidden costs can creep up and revenue might not grow so well if there’s a recession or if Target loses its market share. But if we have the conviction that these things won’t happen, our model tells us to buy and invest heavily in future growth.