Know When to Sell a Stock

The decision as to when to sell a stock is one of the most difficult components of investing While the the popular "buy-and-hold" approach to investing involves holding quality stocks for an indefinite time period, this does not mean there are not occasions in which to sell. A stock becoming overvalued, harvesting short-term tax losses, or re-balancing a portfolio are all valid reasons to sell a stock.

Steps

Selling When A Stock Is Overvalued

1. Learn the difference between market value and intrinsic value. A stock essentially has two values. The market price refers to the share price you see when you go to buy or sell a stock. This is contrasted with the intrinsic value of the company, which is the true value of the company, independent of what people are willing to pay for it at the current time.
   • A stock considered overvalued when its market value exceeds its intrinsic value. For example, if a stock is trading at $30 per share, and it has been determined its intrinsic value is $25 per share, the stock would be considered overvalued.
   • This would be reason to sell, since the basic idea is that over time, a stock's market value will trade in line with its intrinsic value. This would occur as investors begin to sell off the stock in response to the stock not meeting the high expectations inherit in the market price.
2. Determine intrinsic value. Understanding if a stock is overvalued therefore involves calculating intrinsic value. There are many methods for doing this, some of which are highly involved and complex, and others which are more straightforward.
   • First, it is important to define intrinsic value. While there are many definitions, a commonly accepted definition is that the true value of a stock is equivalent to the sum of its future earnings. Calculating this directly, however, involves extensive estimations and projections of a company's growth rate.
   • A more practical approach is to use peer comparison.This method compares the value of your stock to other stocks in the industry to determine if it is overvalued. If your stock is much more expensive than other stocks in your industry without good reason, this may mean the stock is overvalued, and a candidate for sale. In this case, you are using your stock's relationship to its peer group to roughly approximate it's intrinsic value.
3. Determine price-to-earnings ratio. How do you determine current value of a stock? The price-to-earnings ratio, or P/E ratio is one method. The P/E ratio takes a company's current share price, and divides it by the current earnings, to essentially determine how many dollars an investor is willing to pay per dollar of company earnings.
   • For example, if your company is trading at $60 per share, and has an earnings per share of $5, its P/E ratio would be (60/5), or 12. This is also known as the "multiple", or how many times earnings an investor is willing to pay for a dollar of this company's earnings.
   • Therefore, if Company A is trading at 12X earnings (or a P/E of 12), and Company B is trading at a P/E of 10, Company A is more expensive. Note that "more expensive" has nothing to do with the share-price, and is instead is a reflection of how expensive the share price is relative to earnings.
4. Compare the P/E ratio to the industry average P/E. By comparing the P/E ratio of the company in question to the average of its industry, you can determine if it is overvalued.
   • To find the peer average P/E ratio, you can use websites like Morningstar.com, and look up "Industry peers" on the page of the stock you are interested in.
   • If you are interested in a fertilizer company, for example, you would look up the P/E ratio of the fertilizer company, and then the average P/E ratio for all the companies in the fertilizer industry to compare. If the P/E ratio of your company is much higher, it may be a candidate for sale.
5. Determine if a premium is warranted. Is the P/E of your stock much higher than its peers? If so, determine if this premium is warranted before selling.
   • As mentioned earlier, the intrinsic value of a company is equivalent to the sum of its future earnings. This means if a stock has a higher future growth rate, it will be worth more. Check if your company has a higher 5-year growth rate than its peers (you can find this data on Reuters.com). If your company has a projected growth rate of 15% annually, compared to only 5% for its major competitors, trading at a slightly higher P/E may be justified.
   • Look at profitability. Examine the return-on-equity and gross profit margins of the company you are interested in. Return-on-equity simply indicates the return the company is getting on the money shareholders invested. Gross profit margin indicates the proportion of total revenues represented by profits.
6. Sell the stock if necessary. If the stock is trading at a higher P/E ratio than its peers, with average, or below average growth, and average, or below average profits and return-on-equity, selling may be an option.
   • If you have made significant profit on the stock, and still believe in the long-term story of the company, consider selling 50% of your position and maintaining the remainder.

Selling To Re-Balance A Portfolio

1. Examine your asset allocation goals. Asset allocation refers to the percentage of your portfolio allocated to each type of asset class. Asset classes can include equities (which include stocks, mutual funds and exchange-traded funds), bonds, cash, and much more. Your portfolio should have an appropriate allocation to each of these categories depending on your appetite for risk, and investing goals.
   • Money-market funds or treasuries have the lowest risk also the lowest returns. Investment-grade bonds are considered higher risk and higher return than money-market funds or treasuries, and stocks are considered the highest risk and highest return options.
   • Therefore, if you are a conservative investor who is more concerned with protecting your capital, while earning a small but stable return, a portfolio of 75% bonds, 15% stocks, and 10% cash or money-market funds would be appropriate. If you are looking for a balance between risk and return, a 50% stock, and 10% cash, and 40% bond approach would be reasonable. If you are an investor willing to take on high-risk is exchange for potentially high returns, 80-90% stocks and 10% bonds or cash would be appropriate.
2. Understand re-balancing. Re-balancing refers to the act of selling or buying stocks to either restore your target asset allocation (as discussed above), or to establish a new asset allocation.
   • Re-balancing can occur on many time-frames, but an often recommended time frame is once a year, since this reduces fees associated with transactions. Therefore, re-balancing would involve checking on your asset allocation annually.
   • If you find one asset class has grown beyond your target asset allocation, and you still have faith in your original asset allocation, selling could be a possibility. For example, it is possible that ,if you opted for a 60% stock, 40% bond allocation, this allocation could change to 64% stocks and 36% bonds, if the stock market does extremely well.
   • For example, assume you had a $100,000 portfolio, with $60,000 in stocks and $40,000 in bonds at the end of last year. At the end of the year, you have $80,000 in stocks, and $45,000 in bonds. At this point, your portfolio would be worth $125,000, with stocks representing 64%, and bonds representing 34%.
3. Calculate how much to sell. In the above example, if you still want to keep your 60% stock, and 40% bond allocation, you would need to sell some stock to bring it back down.
   • To determine how much to sell to create a 60% stock allocation once again, begin with your total portfolio value, or $125,000. Multiply $125,000 by 0.60 (or 60%), and this will tell you what 60% of $125,000 is. In this case, it would be $75,000. Since you currently have $80,000 in stock, you would need to sell $5,000 to re-balance your portfolio.
4. Sell the stock. Seeing your stock allocation rise beyond your target amount can be an excellent reason to sell. The question is, how do you determine which stock to sell (assuming you have more than one)?
   • In this case, you have a few options. The first is to sell the stock that is most overvalued. Conversely, you can also sell a stock that has lost money in order to benefit from tax loss harvesting. You can also consider looking to your biggest winners, and consider selling 50% of a winning stock as a way to lock-in your profits.
5. Ensure you do not sell without good reason. It may be tempting to sell a stock that has been flat over the course the year for re-balancing purposes, and move that money into a winning stock that may or may not be overvalued. Be very cautious with this
   • If the stock that remained flat is still undervalued, or is still a good investment according to whatever means you used to analyze it, hold that stock unless you have an alternative with a better risk/reward profile. It is not uncommon for the market to take a long period to recognize the value of a particular company.
   • Try to avoid selling stocks simply because they have lost value. While it may be tempting to sell a stock after it has lost 10% or 15%, a selling decision needs to be based not on what is happening to the price of the investment, but instead on changes to your initial reason for investing. Stocks can be incredibly volatile and can move due to factors not related to the individual business at all (like events in the global economy). Therefore, only sell when there has been a fundamental change to the business that refutes your original reason for investing (like the stock no longer being undervalued, or a major change in the competitive landscape).

Selling To Harvest Tax Losses

1. Learn about capital gains taxes. When you sell a stock for a profit, you are subject to what is known as a capital gains tax, or a tax on your profit. Profits can be taxed at two levels.
   • If you hold your investment for more than one year, the profits will be taxed as capital gains at their tax rate, which is 15%.
   • If you held your investment less than one year, they will be taxed as normal income. This means they would be taxed at the same level as your regular income as per your tax return.
2. Understand tax loss harvesting. Tax loss harvesting refers to selling a stock at a loss, which can then be used to offset capital gains taxes on a gain. This is a powerful tool to use your losses to reduce your overall taxes.
   • This means that if you sold a stock for a large capital gain this year, and also decide to sell a different stock (which may have lost money and be overvalued), you can use to the loss to offset the gain, and reduce your overall taxes.
   • For example, assume you held a stock for over one year, and that stock increased in value from $10,000 to $17,000. If you sell that stock, you would normally be taxed $1,050, or 15% of the gain ($7,000). If you also had a stock that has lost a total of $5,000, you can choose to sell that stock to offset the $7,000 gain. In this case, your net gain would only be $2000, and you would therefore only pay $300 in taxes (15% of $2000).
   • Short-term capital losses must first be applied against short-term capital gains (under a year), any extra can be applied against long-term gains (over a year). Long-term losses must first be applied to long-term gains, and then to short-term gains.
   • If total losses for the year exceed gains, you can apply up to $3,000 towards reducing personal income taxes, and any extra can be carried forward to additional years to reduce future gains.
3. Learn the wash-sale rules before deciding to sell. A wash sale refers to selling a stock at a loss, and then re-purchasing the same stock, or a substantially similar stock, within a short time period. In this case, the IRS will disallow using the loss to offset gains.
   • For example, you bought a XYZ stock for $100 in January 2014. On November 15th of the same year, you sell it at $90 and plan to claim the $10 per share loss on your income tax return. However, you hear a rumor that the company is selling very well going into the Christmas holidays after Black Friday so you buy the stock back at $88 on December 3rd.
   • The government decides that you bought again because you expect the price to go up. They know that there was no real loss incurred. It was just a temporary exit from the investment which you plan to hold going forward.
   • There is nothing that prevents you from buying and selling as often as you want, you just can’t deduct short-term losses if you break the wash sale rule.
4. Sell a stock for tax harvesting purposes. If you have a stock that has lost money, you can consider selling it for tax harvesting purposes. There are, however, several considerations.
   • Make sure you have good reason to sell any stock with losses, and make sure not to sell for tax-loss harvesting purposes alone. For example, if you have a stock that has lost money, and has become overvalued, this may be grounds to sell. Similarly, if you have a stock that has lost money, and you need to re-balance your portfolio, selling your losing stock can be a wise idea if the other stocks are still favorable.

Tips

• In addition to all of the other cost considerations, you should also think about trading costs. This is the cost from your broker to buy and sell. This is added to the tax implications already discussed. Brokerage fees vary widely as do tax implications.

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