Time to Sell Varian Medical Systems?

Should you sell Varian Medical Systems (NYSE: VAR) today?

The decision to sell a stock you've researched and followed for months or years is never easy. But if you fall in love with your stock holdings, you risk becoming vulnerable to confirmation bias -- listening only to information that supports your theories, and rejecting any contradictions.

In 2004, longtime Fool Bill Mann called confirmation bias one of the most dangerous components of investing. This warning has helped my own investing throughout the Great Recession. Now I want to help you identify potential sell signs on popular stocks within our 4-million-strong Fool.com community.

Today I'm laser-focused on Varian Medical Systems, ready to evaluate its price, valuation, margins, and liquidity. Let's get started!

Don't sell on price
Over the past 12 months, Varian has risen by 40.6% versus an S&P 500 return of 11.3%.  Investors have every reason to be proud of their returns, but is it time to take some off the top?  Not necessarily. Short-term outperformance alone is not a sell sign. The market may be just beginning to realize Varian's true, intrinsic value.'For historical context, let’s compare Varian's recent price with its 52-week and five-year highs. I've also included a few other businesses in the same industry or a related one.

Source: Capital IQ, a division of Standard & Poor's.

Varian is basically at its 52-week high, so we need to dig into the valuation to ensure that these previously untested highs are justified.

Potential sell signs
First up, we'll get a rough idea of Varian's valuation. I'm comparing Varian's recent P/E ratio of 22.2 with where it's been over the past five years. 

Source: Capital IQ, a division of Standard & Poor's.

Varian's P/E is lower than its five-year average, a possible indication that the stock is undervalued. A low P/E isn't always a good sign, since the market may be lowering its valuation of the company because of less attractive growth prospects. But it does indicate that, on a purely historical basis, Varian looks cheap.

Now let's look at the gross-margin trend, which represents the amount of profit a company makes for each $1 in sales, after deducting all costs directly related to that sale. A deteriorating gross margin over time can indicate that competition has forced the company to lower prices, that it can't control costs, or that its whole industry's facing tough times. Here's Varian's gross margin over the past five years.

Source: Capital IQ, a division of Standard & Poor's.

Varian is having no trouble maintaining its gross margin, which tends to dictate a company's overall profitability. That's solid news; however, investors need to keep an eye on this metric over the coming quarters. If margins begin to dip, you'll want to know why.

Next, let's explore what other investors think about Varian. We love the contrarian view here at Fool.com, but we don't mind cheating off our neighbors every once in a while. For this portion of our research, we'll examine two metrics: Motley Fool CAPS ratings and short interest. The former tells us how Fool.com's 170,000-strong community of individual analysts rates the stock, and the latter shows what proportion of investors is betting that the stock will fall. I'm including other peer companies once again for context.

Source: Capital IQ, a division of Standard & Poor's.

The Fool community is rather bullish on Varian. We typically like to see our stocks rated at four or five stars. Anything below that level is a less-than-bullish indicator.  I highly recommend that you visit Varian's stock-pitch page to see the verbatim reasons behind the ratings.

Here, short interest is at a mere 4.4%. A number like this typically indicates that few large institutional investors are betting against the stock.

Now let's study Varian's debt situation, with a little help from the debt-to-equity ratio. This metric tells us how much debt the company's taken on, relative to its overall capital structure.

Source: Capital IQ, a division of Standard & Poor's.

Varian has done a good job of reducing its debt over the past five years. With total equity increasing over the same time period, debt-to-equity has consequently decreased, as the above chart shows. Based on the trend alone, that's a good sign. I consider a debt-to-equity ratio below 50% to be healthy, though the number varies by industry. Varian is currently below this level, at 3.4%.

The last metric I like to look at is the current ratio, which lets investors judge a company's short-term liquidity. If Varian had to convert its current assets to cash in one year, how many times over could it cover its current liabilities? As of the last filing, the company had a current ratio of 1.86. That's a healthy sign. I like to see companies with current ratios equal to or greater than 1.5.

Finally, it's highly beneficial to determine whether Varian belongs in your portfolio -- and to know how many similar businesses already occupy your stable of investments. If you haven't already, be sure to put your tickers into Fool.com's free portfolio tracker, My Watchlist. You can get started right away by adding Varian.

The final recap

Varian has failed none of the quick tests that would make it a sell. That's great, but does it mean you should hold your Varian shares? Not necessarily. Just keep your eye on these trends over the coming quarters.

Remember to add Varian to My Watchlist to help you keep track of all our coverage of the company on Fool.com.

If you haven't had a chance yet, be sure to read this article detailing how I missed out on more than $100,000 in gains through wrong-headed selling.