In my previous article, I argued that investors should treat the tax impact of their stock sales as increasing the stock's bid/ask spread before they decide to sell. Near the end of the article, I presented a simple formula for determining this bid/ask spread and encouraged investors to use it when deciding whether they should sell or hold.
The key part of that formula was determining a stock's fair value, and the clear implication was that you should sell a stock as soon as the after-tax amount you can get from the sale equals the stock's fair value to you. Now, in this article, I'll address why you should sell a stock when it reaches its fair value.
How much is it worth?
Right off the bat, I'll have to disappoint you: No one can give you a tried-and-true formula for determining a company's exact fair value, because there's more than one way to determine it. You can discount the company's future stream of free cash flows to the present, for example. Or you can use multiples of earnings, cash flows, or book value. You can even estimate how much a strategic or financial buyer might pay to take over the entire company. Furthermore, even if we all used the same valuation tools, what I might consider a company's fair value will differ drastically from what other investors might think. That's what makes a market.
But while valuation is an imprecise science, it's not completely irrational, either. We all deal with fair-value estimates every day. For example, when you shop, you have in your mind a price range of how much you think you should pay for a pineapple from Fresh Del Monte Produce (NYSE:FDP), a necklace from Tiffany (NYSE:TIF), a sweater from Gap (NYSE:GPS), or a new iPod nano from Apple Computer (NASDAQ:AAPL). You might base your decision on how badly you want a certain item right now or how much you'd be able to resell the item for in the future. The main point is that, whichever method you pick, there exists a range of prices where you're likely to tell yourself, "Yep, that's about right -- this asset's price is roughly in line with its current worth."
You can't dine on your brokerage statements
There's an extra wrinkle to contend with here, though: While you can eat a pineapple or wear a necklace, stock certificates have no consumption value. At heart, for the great majority of us, stock-picking is simply an act of arbitrage. All we ever intend to do with our stocks is keep them in our portfolios until, someday, we find someone else who thinks they're undervalued and buys them from us. (Note that income investors are an exception, since they often depend on the steady stream of cash payments from dividend-paying companies like Bank of America (NYSE:BAC) and Johnson & Johnson (NYSE:JNJ) for their sustenance). And when you're in the business of arbitrage, you think that you're picking up an asset for less than you'd be able to sell it to someone else in the future. Furthermore, you also think that you're being properly compensated for the risk that your analysis is wrong and that your asset won't ever reach the valuation you've placed upon it.
Let's then consider what fair value means for an arbitrageur. To say that a company is fairly valued suggests that the potential reward of owning the shares corresponds to the amount of risk an investor assumes by purchasing the shares. (Here, I consider risk to be the potential that your return on investment won't meet your expectations). On the other hand, to claim that a stock is undervalued implies that the stock's potential reward outweighs its potential underperformance. By definition, then, fairly valued stocks have no margin of safety and, thus, give you no reason to own them.
So, since many stocks have no consumption value for you and there's no need to purchase a fully valued asset, the place to start when determining a stock's fair value is to ask yourself this question: At what price would I no longer be willing to buy shares of this company? Whatever value you come up with is also the price at which the company's shares should exit your portfolio.
Holding is the same as buying
The beauty of a highly liquid market is that you can exit from a position at practically any time. Mr. Market quotes you a bid price from 9:30 a.m. to 4:00 p.m. Eastern time every day -- and even longer if you deal in premarket or aftermarket trading. Since this ability to bid is virtually always at your disposal, your decision not to sell a stock on any given day, hour, or even minute implies that you think you can still make money by holding on to it. At heart, this is exactly the same decision as purchasing the stock. While I wouldn't encourage anyone to re-evaluate their investment decision on a minute-by-minute basis, the fact that this exit option is consistently present should never escape you. By not taking it, you're committing to the investment process the same way a first-time buyer is. This is why you should think of the tax effect on your stock sales as essentially lowering the bid price.
Undoubtedly, some of you may be thinking that my argument goes against the idea of letting your winners run. In other words, won't this approach cause you to sell out of your winning stocks -- your best ideas -- too early? I don't think so. First, while the danger of selling too soon exists whenever you choose to part with shares of any company, it's no greater than the risk of being too optimistic in your original analysis and never seeing its value fully realized. But, more importantly, your fair-value estimate should not be immutable. A single company's prospects may not change on a daily basis, but they do change as a result of new information you glean from quarterly reports, your own outside research, or even your expectations of where the market is headed. These, and others, are all identifiable reasons for holding on to a stock that can be expressed numerically -- by simply raising or lowering your estimate of the company's fair value.
What if I miss the next Wal-Mart?
I should offer one final word of warning. If you follow these rules, it is unlikely that you will hold shares of a company for decades. Odds are high that a great company's price will at some point exceed even your most optimistic fair-value estimate. If that happens, shed no tears; it's still time to sell. Though a seemingly great company may remain overvalued for a long time, though it may rise many times over while sporting a ridiculous valuation, there is no way to know in advance which stocks will continue to soar and which will stagnate or, worse, crash and burn. Better safe than sorry. Google (NASDAQ:GOOG), anyone? Once the stock becomes attractive again according to your valuation methodology, you can jump back into the game.
But what if the stock never comes back down to your fair-value estimate? That can, and will, happen. If it happens too often, that likely means that there's something wrong with your methodology for determining a stock's fair value and that you should re-examine how you value stocks. But even if your valuation techniques are always sound, some companies will, through random chance alone, surpass all expectations. Forget that such a company may have once graced your portfolio, and move on. While the sting of missing out on such a winner may be unpleasant, it's still easier to deal with than having to explain to yourself, after a precipitous 25% drop, why you held on to a stock that your valuation methodology had indicated to be overvalued.
What to do?
The practical advice of these two columns can be summed up simply: You should periodically re-examine your original analysis of a stock's fair value. If nothing has changed fundamentally, but the stock's after-tax price has zoomed to your fair-value estimate, it's time for a pat on the back -- you've bought low and now it's time to sell high. Just make sure that the stock's bid price takes into account the tax bite and will allow you to realize the actual fair-value amount when you sell.
Fresh Del Monte is a recommendation of the Motley Fool Hidden Gems newsletter service. Gap is a Motley Fool Stock Advisor pick.
Fool contributor Marko Djuranovic does not own shares of any company mentioned in this article. The Motley Fool has a disclosure policy.
