Calibrating Target Prices with Risk/Reward
A target price is not a decision. You have calculated that a stock is worth $85, and it trades at $70. Is that a buy? It depends on your downside if you are wrong. Calibrating target prices with risk/reward ratios converts static valuation outputs into position sizing decisions that account for uncertainty.
Why this matters: With a 3:1 reward-to-risk ratio, you can lose 3 out of 4 trades and still break even. The ratio determines how aggressive you can be, not just whether the stock is cheap.
The Risk/Reward Framework (Core Mechanics)
Risk/reward ratio compares your potential upside to your potential downside:
Risk/Reward Ratio = Potential Upside / Potential Downside
Where:
- Potential Upside = Target Price - Current Price
- Potential Downside = Current Price - Downside Price (often your stop-loss or bear case)
Worked Example: Software Company
- Current price: $100
- Your target price (base case): $130
- Your downside price (bear case): $80
Upside: $130 - $100 = $30 Downside: $100 - $80 = $20 Risk/Reward: $30 / $20 = 1.5:1
The point is: A 1.5:1 ratio means you need to be right more than 40% of the time just to break even. Is your analysis good enough to achieve 50%+ accuracy? If not, the position size should be modest.
Setting the Downside Price (Where the Thesis Breaks)
The downside price is not arbitrary. It should represent the price at which your investment thesis is invalidated.
Three approaches to setting downside:
1. Valuation-Based Downside
Use your bear case valuation (pessimistic but plausible assumptions).
Example: Your base case assumes 12% revenue growth. If growth comes in at 6% (historical trough), your DCF produces $75. That is your valuation-based downside.
2. Technical Support Level
Identify the price level where the stock has historically found buyers. This is not valuation; it is market structure.
Example: The stock has bounced off $85 three times in the past 18 months. If it breaks below $85 on volume, historical support has failed.
3. Thesis Invalidation Point
What specific event would prove your thesis wrong? What would the stock trade at if that occurred?
Example: You are long because you expect FDA approval. If the FDA rejects the drug, the stock goes to $40 (based on pipeline value excluding that drug). That is your thesis invalidation downside.
The durable lesson: Your downside should represent a scenario, not just a percentage decline. "20% downside" is meaningless; "stock at $80 if growth disappoints" is actionable.
Converting Ratios to Win Rate Requirements
Every risk/reward ratio implies a minimum win rate to break even:
| Risk/Reward Ratio | Minimum Win Rate to Break Even |
|---|---|
| 1:1 | 50% |
| 1.5:1 | 40% |
| 2:1 | 33% |
| 3:1 | 25% |
| 4:1 | 20% |
The formula: Minimum Win Rate = 1 / (1 + Risk/Reward Ratio)
Example: At 3:1 ratio, Minimum Win Rate = 1 / (1 + 3) = 25%.
Why this matters: If you believe your analysis is correct 60% of the time (optimistic for most analysts), you need at least a 1.5:1 ratio to have positive expected value. At 1:1, even 60% accuracy barely breaks even after transaction costs.
Probability-Weighted Target Prices
A single target price ignores uncertainty. Probability weighting uses your scenario analysis to calculate expected value.
Worked Example: Industrial Company
You have three scenarios:
| Scenario | Probability | Target Price |
|---|---|---|
| Bull case | 25% | $150 |
| Base case | 50% | $110 |
| Bear case | 25% | $70 |
Expected Value = (0.25 x $150) + (0.50 x $110) + (0.25 x $70) Expected Value = $37.50 + $55.00 + $17.50 = $110
Current price: $95 Expected upside: $110 - $95 = $15 (15.8%)
But now calculate expected downside. If the bear case occurs, you lose $95 - $70 = $25.
Probability-weighted expected return: (0.25 x 55) + (0.50 x 15) + (0.25 x -25) = 13.75 + 7.50 - 6.25 = 15%
The point is: The probability-weighted return is positive, but the 25% chance of losing 26% matters. Position sizing must account for that tail risk.
Position Sizing from Valuation (The Kelly Criterion Lite)
The Kelly Criterion calculates optimal position size based on edge and odds:
Kelly % = (bp - q) / b
Where:
- b = odds (reward/risk ratio)
- p = probability of winning
- q = probability of losing (1 - p)
This formula is too aggressive for most investors. Half-Kelly (dividing by 2) is more practical.
Worked Example: Applying Half-Kelly
- Reward/risk ratio (b): 2:1
- Your estimated probability of thesis being correct (p): 60%
- Probability of being wrong (q): 40%
Kelly % = (2 x 0.60 - 0.40) / 2 = (1.20 - 0.40) / 2 = 0.80 / 2 = 40%
Half-Kelly = 40% / 2 = 20% of portfolio
The durable lesson: Even with a 60% win rate and 2:1 odds, the mathematically optimal position is only 20% of your portfolio. Concentration is rarely justified by the math.
Practical Position Sizing Grid
For individual investors, a simpler framework:
| Risk/Reward | Your Conviction | Position Size |
|---|---|---|
| < 1.5:1 | Any | Pass or minimal (1-2%) |
| 1.5:1 - 2:1 | Low | 2-3% |
| 1.5:1 - 2:1 | High | 3-5% |
| 2:1 - 3:1 | Low | 3-5% |
| 2:1 - 3:1 | High | 5-7% |
| > 3:1 | Low | 5-7% |
| > 3:1 | High | 7-10% |
Why this matters: A 10% position in a single stock is aggressive. It requires both exceptional risk/reward (>3:1) and high conviction. Most positions should be 3-5%.
Updating Targets as Prices Move
Your risk/reward ratio changes as the stock price moves. A position that was attractive at $70 may no longer be attractive at $90.
The discipline:
After 20% gain, recalculate:
- New current price: $84 (up from $70)
- Same target: $100
- Same downside: $55
New upside: $100 - $84 = $16 New downside: $84 - $55 = $29 New ratio: $16 / $29 = 0.55:1
The risk/reward has inverted. What was a buy at $70 is now a potential sell at $84.
The point is: Target prices are not permanent. As prices move toward your target, the risk/reward deteriorates. Disciplined investors take profits when ratios compress.
Integrating Analyst Price Targets
Sell-side analyst price targets are data points, not answers. Research shows:
- Most analysts use trailing P/E ratios, not DCF or discount rates
- Price targets typically represent 6-12 month outlook
- Targets change frequently and are not reliable predictors of actual returns
- Analyst targets alone are insufficient for buy/sell decisions
How to use analyst targets:
- Compare consensus to your own target. If consensus is $120 and your DCF says $80, investigate the gap.
- Look at the range. If analyst targets span $90-$140, there is high uncertainty.
- Check the trend. Rising targets suggest improving sentiment; falling targets suggest deterioration.
The durable lesson: Use analyst targets as a sanity check, not a decision driver. Your own analysis should determine your position, not Wall Street's.
The Complete Decision Framework
Before entering any position:
- Calculate base case target price from your valuation
- Calculate bear case price from your downside scenario
- Compute risk/reward ratio (upside / downside)
- Determine minimum win rate required to break even
- Assess your actual estimated win rate honestly
- If estimated win rate > minimum, calculate position size from the grid
- If estimated win rate <= minimum, pass on the position
Why this matters: This process forces you to quantify your conviction and size positions appropriately. It prevents both over-concentration (betting too much on shaky ideas) and under-positioning (betting too little on high-conviction ideas).
Next Step
Take your most recent stock purchase. Calculate the risk/reward ratio at the price you paid. What was your implied minimum win rate? What was your actual position size? Does your position size match the math, or did you over- or under-allocate? Use this analysis to calibrate your next position.