Published in: Stocks

When to Sell a Stock?

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When to Sell a Stock?

Authored by: J. Froentjes
Last updated: 23 July 2022

When to sell a Stock?

It isn’t easy to know when to sell a stock, but focus on the underlying business’s performance, competitive positioning, and value. Avoid forecasts made by so-called experts who claim to know what will happen soon. Finally, keep in mind that stocks are ownership holdings in actual firms, and their long-term profitability will drive your return as a shareholder.

A popular way for investors to look at company debt levels is by calculating the debt ratio.
For investors, it would be wise to look at free cash flow to determine whether a company can pay a stable dividend in the case of a sudden decrease in cash flow.
This article illustrates how you can use free cash flow to determine the safety of your dividend.
As an investor, you should look at a company’s dividend history.
Diversifying your portfolio can help reduce risk by distributing assets.
Considering the value of opportunity costs can help people and businesses make more lucrative decisions in their investing journeys.
The silent killer of investing in securities is stock dilution. Stock dilution happens when a company’s activity raises the number of outstanding shares, reducing current shareholders’ ownership proportion.

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Understanding valuation

Price to Earnings Ratio

The PE ratio indicates the price investors pay for each euro gained by the company. Overall, the greater the P/E ratio, the more money investors are ready to spend for each euro won. Therefore, businesses with a high P/E ratio (greater than 30) frequently experience rapid growth. P/E ratios are then calculated based on either traction growth or a drop in future expectations.

PE ratios can offer a great indication as to whether you should remain invested in a stock, whether you should sell, or even buy more. This ratio is popular because it tells the investor about the public’s willingness to pay for the company’s earnings. This willingness means that if an investor is ready to pay a premium for future earnings, the prospective earnings must be looking good, competition has to be low (also in the future), and the company should have an established MOAT. Investors should handle a company without either of these characteristics with care since companies like this scream overvaluation, especially with PE ratios above 30.

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Every company’s P/E ratio is unique. Therefore, it is also necessary to compare the ratios of several companies in the same industry. For example, consider the technology, health care, and consumer safety industries. Most companies that can grow faster than the average have higher P/E ratios. The S&P 500’s average price-to-earnings ratio has historically been between 13 and 15, which investors consider a favorable PE.

In addition, the PE ratio offers a way to compare your investment to competitors in the market. For example, suppose a direct competitor, not a market leader, is trading for a lower PE. In that case, it can still be a better deal regardless of whether it’s the biggest company in that sector or industry.

If a firm has a high PE ratio, the market believes it has strong growth potential and is prepared to overspend today based on future earnings. However, in a recession, companies cannot keep these expectations and high PE stocks could fall steeply.

Selling stocks from a value investing perspective.

Based on specific variables, analysts develop financial models for asset value. For example, they might use discounted cash flows produced by dividing the breakdown of a company’s earnings and free cash flow by their respective discount rates. In addition, value investors often use a handful of metrics to establish a formula that works for them. Investors make these formulas to determine the valuation of a company and whether the underlying fundamentals justify it. This strategy offers a security’s value range based on several hypotheses. Thus, several circumstances and assumptions may result in price ranges where the investor thinks it would be best to buy or sell a share.

Why debt levels are so important?

Debt is crucial when addressing the cost of capital in a finance lesson. However, debt is not necessarily bad when a company has it. One of the critical motivations for starting a business is achieving a greater rate of return than you would by investing your money elsewhere. Increased returns mean that as a business owner, you should expect a return on equity that is more substantial than the cost of debt. More debt allows you to have a smaller equity foundation, resulting in a higher after-tax profit/equity return rate. In addition, the interest charged on the loans is tax-deductible and can be used to decrease taxes long-term.

A popular way for investors to look at company debt levels is by calculating the debt ratio. A company’s debt ratio displays whether or not it has debt and, if so, how its credit funding corresponds to its assets. Investors calculate this metric by dividing total liabilities by total assets, with larger debt ratios suggesting more debt financing. Debt ratios can describe the financial health of individuals, businesses, and other entities.

However, when a company cannot pay down debt during, for example, a recession, there is a risk of insolvency. Moreover, when companies cannot come up with funds to pay down interest and debt, they risk losing collateralized property. When things recover, lenders will ask for higher interest because the perceived risk on loans has become significantly higher.

Is the company offering a stable dividend?

When you’ve realized your gains on a stock offering a stable dividend every quarter, keeping this stock can be very tempting since it provides you with a quarterly cash payment. However, many companies pay volatile dividends. So, for investors, it would be wise to look at free cash flow to determine whether a company can pay a stable dividend in the case of a sudden decrease in cash flow. This article illustrates how you can use free cash flow to determine the safety of your dividend.

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If dividends are not paid out regularly or can’t be because of limitations in cash flow, it may be wise to sell your investments. Therefore, as an investor, you should look at a company’s dividend history. If a corporation has a lengthy history of dividend payouts, a decrease or removal of the dividend amount may indicate to investors that the company is in danger.

However, some investors argue you should avoid too many dividend stocks altogether. While dividends are an excellent and stable payout, the most considerable downside is tax inefficiency. Dividends are taxed once in the form of a company’s income and a second time when it’s distributed to shareholders since you must pay dividend tax. Therefore, some investors argue that shareholders should reinvest dividends in the business for the company’s sake.

Rebalancing or adjusting your portfolio

A typical motive for selling equities is to rebalance a portfolio. For various reasons, a portfolio might become imbalanced or improper for your financial goals. Rebalancing your stock picks might be due to a life event such as marriage, divorce, retirement, the birth of a child, or just an unintentional concentration of money in one area.

Many passive investors maintain the principle of investing 90-95 percent in index funds and picking 5-10% in stocks they like more than speculating. You might want to sell some of your stocks to limit risk when your stock-picking exceeds that percentage. Index funds spread your money over an entire market, sector, or geographical location and offer investors a great way to diversify. However, when you reach above 10 percent on individual stocks, you’re increasing your risk significantly.

In other cases, you may be heavily invested in one part of the world, which can be scary when it comes to government regulations or natural disasters. For example, if you only invest in Chinese companies, you should know regulatory bodies might significantly impact how a stock performs over time.

Diversifying a portfolio can help reduce risk by distributing assets among several equities, industries, or investments. For example, if one company or sector falls, the portfolio can withstand the loss better since you spread your money over multiple investments. Diversifying and placing assets in categories of risk and return is called asset allocation. Asset allocation is a method that helps balance risk and returns by distributing a portfolio’s assets based on an individual’s financial goals, risk tolerance, and investing timeframe.

A stock reached the value you like

Many investors use pricing targets to determine when to sell a stock. Investors that employ this approach will often select a price range for when to sell the stock when they purchase it. As the price of a stock rises, investors can begin selling the position once it reaches the price target range. Investors can either sell everything at the price objective or gradually exit the position at several price targets over time.

However, many experts oppose this strategy since the fundamentals of companies can change, and over the years, companies can show different prospects in terms of future performance. The belief is that if a company doesn’t fundamentally change, there is no need to sell a stock. As Warren Buffet claims, his preferred holding time is forever.

Opportunity cost

The opportunity cost is the gain an individual would have obtained if they had taken an alternative. The emotional opportunity cost often weighs heavier than the actual opportunity cost. People often feel the fear of missing out and overestimate how many gains another option would bring them. Therefore, it is vital to research average annual percentages of profits and remain realistic about the future.

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To correctly assess opportunity costs, the costs and advantages of each possible alternative must be analyzed and compared against one another. Considering the value of opportunity costs can help people and businesses make more lucrative decisions in their investing journeys.

A merger, fusion, or change of ownership

The stock price can sometimes skyrocket when a company acquires another for a hefty premium. As a result, following the merger, investors may sell their shares. First, examining whether the company’s fundamentals have improved after the merger or acquisition is critical. If not, it may be time to sell and invest the funds elsewhere.

In the case of a merger, prices can increase significantly as the company tries to work toward a market monopoly. Second, investors must assess whether a market monopoly is realistic and if demand can keep up with price increases. In addition, a merger forces two different companies to suddenly work together, often with significant drifts in company culture and work ethic. A sudden change in company culture can result in conflict and decrease employee performance.

You need the money

For long-term investors, selling your shares simply because you need money is not the best option. However, if you’re expecting that you will need a substantial amount of money in a timeframe where you can’t just save up (e.g., a wedding, honeymoon, or another life event) and it’s something you want, there is something to say for selling your stock. A recession is always imminent, and in hindsight, it could either work out well or not. Important here is to realize what kind of opportunity cost comes with selling your shares.

The tax benefits of selling a stock

Sometimes an investment that has lost value might still be beneficial—or at least not so awful. For example, tax-loss harvesting is a practice that converts a losing investment into a tax-profitable one.

Tax-loss harvesting allows you to sell down investments, replace them with substantially equivalent assets, and offset realized investment profits with those losses. Consequently, less of your money is lost to taxes, and more may remain invested and working for you. To conclude, tax-loss harvesting may help you save money now and in the future.

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The company has gone bankrupt.

Bankruptcy may appear to be a reason to sell, especially given that a bankrupt corporation is useless to stockholders in most circumstances. However, for tax reasons, the loss must be sold or realized so that investors can use it to offset future capital gains and a small percentage of regular income tax each year.

Selling a stock immediately after bankruptcy will almost always result in a significant loss, but you may still be able to recoup some cents on your dollar.

A structural shift in fundamentals

If you’re doing everything according to the rules of value investing when selecting individual stocks, you’ll have to consider why you had to buy the stock in the first place. What were the goals you wanted to achieve with the investment? What was your time horizon? In addition, you’ll have to look at what reasons still apply. Have specific ratios changed? What are the prospects for the company?

All the preliminary questions are just the basic questions you should ask yourself, and if it turns out that the fundamentals have structurally changed, you might want to consider selling the stock. For example, stocks can fall in market share because competitors are offering better products or services for lower prices. Companies can see their revenue or sales growth stagnant even without competition. When high inflationary times approach and spending power decreases, some companies suffer greatly, as they are the first services/products to be cut from somebody’s budget. Moreover, when management changes or mergers occur, a shift in decision-making can form a risk for investors. In general, investors strongly dislike unknown factors.