Is It Time to Sell This Stock?

Remember the first time you bought shares of a stock -- hopefully you did some solid research and due diligence and came to the conclusion that it might be undervalued. Maybe you bought shares of Ford Motor (NYSE: F  ) , or Bank of America (NYSE: BAC  ) back in May and thought it was a great deal -- in retrospect, it looks as though the market has rewarded you for finding stocks that were undeservedly beaten down.

Arriving at the right price
However, as important as that first purchase price is, it's just as important to continually evaluate the merits of your stock to determine your ultimate sales price. Unfortunately, many times we get distracted and focus on the wrong things when trying to analyze whether to hold or sell a stock.

For instance, imagine that you had bought your home at the height of the housing boom for about $400,000. Now you are trying to sell it for $450,000 because a few years have passed and you feel that it should have risen in value. This is partly because we are programmed to compare our expectations for the sales price ($450,000) with the original price we paid, or anchor price ($400,000). But the anchor is unimportant -- the only thing that matters is what you can actually sell your house for based on its true value.

In other words, the sensitivity we show to the sales prices is often a result of our memory for the prices we've paid in the past and our desire to be consistent with our previous decisions. However, this doesn't always lead to making the best decisions!

Let's talk stocks
When it comes to investing, we often get stuck on price anchors. If we bought Amazon.com (Nasdaq: AMZN  ) last September at $78, we may think it's time to sell because it's trading around $118 a pop. Similarly, what if we bought shares of Select Comfort (Nasdaq: SCSS  ) in April of last year? It's jumped some 1,000% since then, so many investors would probably take their money and run. But in both cases we're focused on the wrong thing -- our purchase, or anchor, price. Things have changed since then, and now the only thing that matters is what we think the company is worth today.

It's incredibly easy to get tripped up in the stock market. Companies rise and fall at lightning speed, and information is transmitted so quickly that the smallest tidbit of news can send shares soaring or falling in a single day. When the market fluctuates so often, it makes it extremely difficult to stay focused on the intrinsic value of a stock. When a company like Dollar Thrifty Automotive Group has risen by some 3,500% in the last year, it's hard to determine if it's due to a material change or just unwarranted volatility.

Take a look at some of the drastic changes that can happen in just one trading day:

Stock

Price Feb. 16, 2010

Price Feb. 17, 2010

Daily Price Change %

Whole Foods Market (Nasdaq: WFMI  )

$30.52

$34.35

13%

China Agritech (Nasdaq: CAGC  )

$19.40

$21.15

9%

Rackspace Hosting (NYSE: RAX  )

$18.81

$20.11

7%

Sources: The Wall Street Journal and Yahoo! Finance.

As you can see, even billion dollar companies have the potential to move by double digits -- these are great examples of the market value of a stock diverging from the intrinsic value in a single day. How can a company possibly be worth 13% more one day than the previous?

The volatility in today's prices makes us constantly look backward to try and find context for the current price. However, the best way to know when to sell your stock is to ignore anchors and constantly evaluate it's true worth. One of the most common methods of finding fair value is to use a discounted cash flow (DCF) model. Once you have determined if the market value has approached or is exceeding its intrinsic value, it's time to sell -- if not, ignore the market's noise and hold on for the ride.

That's why at the Motley Fool Inside Value we don't just offer stock picks -- we utilize rigorous valuation techniques to constantly keep up to date with the fair value of our recommendations. Not only will you benefit from their expert advice, but you have a team of analysts helping you make the right buy and sell decisions.

If you'd like help getting started, Inside Value offers a DCF calculator that can help put you on the path toward making your own independent valuations. In addition, you can receive an all access pass to all of our past and present recommendations, free for 30-days. Click here for more information.

Already a member of Inside Value? Log in at the top of the page.

Fool contributor Jordan DiPietro doesn't own any of the shares mentioned above. Rackspace Hosting is a Motley Fool Rule Breakers choice. Amazon.com, Ford Motor, and Whole Foods Market are Motley Fool Stock Advisor recommendations The Fool has a disclosure policy that's price never changes.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 22, 2010, at 6:35 PM, Varchild2008 wrote:

    "However, the best way to know when to sell your stock is to ignore anchors and constantly evaluate it's true worth. One of the most common methods of finding fair value is to use a discounted cash flow (DCF) model."

    Good lord... Not for me....no thank you......

    When I evaluate (F) Ford, it is all about channel checking the dealerships and looking at market share. If Market shares stagnates or declines then I will be bolting out the door.

    Because, it seems to me that every miserable earnings release when Ford was losing money still ended up with a market share gain in the U.S. It was this market share gain that helped propel Ford to profitability. If they can continue to increase market share in key markets across the globe and I can continue to see where actual "growth" lies then I can remain a stock holder.

    Otherwise....without seeing much if any market share gains.... It is .... Bye Bye! for me!

  • Report this Comment On February 23, 2010, at 6:26 AM, Faderaman wrote:

    "If we bought Amazon.com (Nasdaq: AMZN) last September at $78..."

    God knows it!

    I thinks this time is a good chance to invest in stocks, gold...

    Conditions have improved for gold equities, and economic policy decisions being made in Washington could further increase the investment appeal of these mining stocks.

    http://top-stocks-usa.blogspot.com/2010/02/gold-stocks-to-bu...

  • Report this Comment On February 23, 2010, at 10:50 AM, MizzouFanVan wrote:

    Oh, let me read all your blogs right away! Not.

    Jordan, I always have trouble trying to figure out a company's cost of capital when determining intrinsic value, probably because no company advertises this anywhere. :) Is 10% usually a good estimate to use with most companies? Or should it be higher for small caps vs. large caps? Just curious what your thoughts are.

  • Report this Comment On February 23, 2010, at 2:00 PM, TMFPhillyDot wrote:

    @MizzouFanVan,

    Thanks for the question -- it's obviously a good one, but also hard to nail down. I would say that yes, 10% is probably the "default" cost of capital that most people use.

    Personally, I don't normally discriminate between small and large caps; when I can, I try to use the WACC, which will give you a better idea b/c you are using a beta coefficient and a cost of debt that is more specific to the actual company.

    In addition, the more unsure you are about the assumptions you're making in your model, the higher the discount rate you should use. Conversely, if you are really comfortable with your assumptions, you can go lower.

    Hope that helps.

    -Jordan (TMFPhillyDot)

  • Report this Comment On February 23, 2010, at 3:56 PM, iamthegodamnstig wrote:

    I could have used this advice when I first started trading.

    “However, the best way to know when to sell your stock is to ignore anchors and constantly evaluate it's true worth”

    I purchased a good amount of Ford at 1.99 and have continued to hold – F especially looks like more of a hold as they continue to surge as others (mainly Toyota) stumble. Where I could have used your advice, however, is at the other end of the spectrum. Investing a bit too heavily into dry bulk shipping companies such as OCNF and DRYS combined with refusing to believe they can go any lower has put me in quite a hole.

    While I agree that it’s important to, “constantly evaluate [a company’s] true worth” I would also like to stress the importance of doing so with a sinking company (pun intended) and getting out before it’s too late.

  • Report this Comment On February 23, 2010, at 3:59 PM, iamthegodamnstig wrote:

    I could have used this advice when I first started trading.

    “However, the best way to know when to sell your stock is to ignore anchors and constantly evaluate it's true worth”

    I purchased a good amount of Ford at 1.99 and have continued to hold – F especially looks like more of a hold as they continue to surge as others (mainly Toyota) stumble. Where I could have used your advice, however, is at the other end of the spectrum. Investing a bit too heavily into dry bulk shipping companies such as OCNF and DRYS combined with refusing to believe they can go any lower has put me in quite a hole.

    While I agree that it’s important to, “constantly evaluate [a company’s] true worth” I would also like to stress the importance of doing so with a sinking company (pun intended) and getting out before it’s too late.

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