Let’s be honest — losing money in the stock market isn’t fun. Plus, prolonged stock under-performance can undermine your investment strategy. But often, investors really don’t know when to sell or when to hold and wait out a storm. Market volatility makes it necessary for every investor to have an exit strategy. Here’s how to know when to dump an under-performing stock.
1. Watch Out for Bubble Territory
Unusually high returns could mean a stock is headed for bubble territory. True, some stocks (Apple, anyone?) are just perennial winners. Typically, however, the party doesn’t last forever, and what goes up must eventually come down. At the end of the year, consider selling off shares of exceptionally well-performing stocks to rebalance your portfolio’s asset allocation and return it to its original allotted positions.
2. Value the Company — Sell Overvalued Stocks
Before you dump a stock, check its Price Earnings Ratio (PE Ratio). The PE Ratio will reveal investor confidence in a company’s stock and what they are willing to pay relative to the company’s actual earnings. To calculate the PE Ratio — divide the company’s stock price by its earnings per share. The standard PE Ratio is anywhere from 15-30. Over 30 is an indicator the company might be overvalued. The PE ratio can be found on websites like Morningstar and Marketwatch.
Another way to value a stock is by calculating the company’s Cash Flow Ratio. To do this, simply divide the cash flow from operations by its current liabilities. The cash flow should be consistent with that of similar companies. If it’s higher, it’s probably overvalued. Some say this is a better performance measure. This information usually can also be found on the aforementioned financial websites.
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