How to Know When to Sell a Stock
Learn the difference between market value and intrinsic value., Determine intrinsic value., Determine price-to-earnings ratio., Compare the P/E ratio to the industry average P/E., Determine if a premium is warranted., Sell the stock if necessary.
Step-by-Step Guide
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Step 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. -
Step 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. , 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. , 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. , 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. , 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. -
Step 3: Determine price-to-earnings ratio.
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Step 4: Compare the P/E ratio to the industry average P/E.
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Step 5: Determine if a premium is warranted.
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Step 6: Sell the stock if necessary.
Detailed Guide
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.
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. , 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. , 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. , 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. , 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.
About the Author
Carolyn Graham
Professional writer focused on creating easy-to-follow pet care tutorials.
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