Time to Sell Medifast?

Should you sell Medifast (NYSE: MED) 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 Medifast, ready to evaluate its price, valuation, margins, and liquidity. Let's get started!

Don't sell on price
Over the past 12 months, Medifast has risen by 9.2% versus an S&P 500 return of 11.3%.  Investors are no doubt disappointed with their returns, but is now the time to cut and run? Not necessarily. Short-term underperformance alone is not a sell sign. The market may be missing the critical element of your investing thesis. For historical context, let's compare Medifast'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.

As you can see, Medifast is down from its 52-week high. If you bought near the peak, now's the time to think back to why you bought it in the first place. If your reasons still hold true, you shouldn't sell based on this information alone.

Potential sell signs
First up, we'll get a rough idea of Medifast's valuation. I'm comparing the company's recent P/E ratio of 22.8 with where it's been over the past five years. 

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

Medifast'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, Medifast 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 Medifasts's gross margin over the past five years.

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

Medifast is having no trouble maintaining its gross margin, which tends to dictate a company's overall profitability. This is solid news; however, Medifast 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 Medifast. 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 bearish on Medifast. 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 Medifast's stock-pitch page to see the verbatim reasons behind the ratings.

Here, short interest is at a high 19.0%. A number like this typically indicates that large institutional investors are betting against the stock.

Now let's study Medifast'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.

Medifast has been taking on some additional 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, although the number can vary by industry. Medifast is currently below this level, at 9.4%.

The last metric I like to look at is the current ratio, which lets investors judge a company's short-term liquidity. If Medifast had to convert its current assets to cash in one year, how many times over could it cover its liabilities? As of the last filing, Medifast has a current ratio of 3.84. That's a healthy sign. I like to see companies with current ratios greater than 1.5.

Finally, it's highly beneficial to determine whether Medifast 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 Medifast.

The final recap

Medifast has failed two of the quick tests that would make it a sell. Does that mean you should hold your shares? Not necessarily. Just keep your eye on these trends over the coming quarters.

Remember to add Medifast 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.