Is American Electric Power a Sell?

Should you sell American Electric Power (NYSE: AEP) today?

The decision to sell a stock you've researched and followed for months or years is never easy. 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 personal 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 American Electric Power, ready to evaluate its price, valuation, margins, and liquidity. Let's get started!

Don't sell on price
Over the past 12 months, American Electric Power has risen 10.8% versus an S&P 500 return of 11.3%. Investors in American Electric Power are likely merely satisfied with their market-matching 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 American Electric Power investing thesis. For historical context, let's compare American Electric Power's recent price to its 52-week and five-year highs. I've also included a few other businesses in the same or related industries:

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

As you can see, American Electric Power 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 American Electric Power's valuation. I'm comparing American Electric Power's recent P/E ratio of 13.4 to where it's been over the past five years.

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

American Electric Power's P/E is higher than its five-year average, which could indicate the stock is overvalued. A high P/E isn't always a bad sign, since the company's growth prospects may also be increasing alongside the market's valuation. However, it definitely indicates that, on a purely historical basis, American Electric Power looks expensive.

Now, let's look at the gross margins 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 is American Electric Power's gross margin over the past five years:

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

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

Next, let's explore what other investors think about American Electric Power. We love the contrarian view here at Fool.com, but we don't mind cheating off of our neighbors every once in a while. For this, 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 rate the stock. The latter shows what proportion of investors are 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 in the middle of the road on American Electric Power. We typically like to see our stocks rated at four or five stars. Anything below that is a less-than-bullish indicator. I highly recommend you visit American Electric Power's stock pitch page to see the verbatim reasons behind the ratings.

Here, short interest is at a mere 1.7%. This typically indicates few large institutional investors are betting against the stock.

Now, let's study American Electric Power'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.

American Electric Power has been taking on some additional debt over the past five years. When we take into account increasing total equity over the same time period, this has caused debt-to-equity to remain near its 5-year average, as seen in the above chart. I consider a debt-to-equity ratio below 50% to be healthy, though it varies by industry.  American Electric Power is currently above this level, at 137.3%.

The last metric I like to look at is the current ratio, which lets investors judge a company's short-term liquidity. If American Electric Power had to convert its current assets to cash in one year, how many times over could the company cover its current liabilities? As of the last filing, American Electric Power has a current ratio of 0.88. This is a bad sign for American Electric Power. The company's current liabilities are greater than its current assets, which means it could have liquidity issues in the short term.

Finally, it's highly beneficial to determine whether American Electric Power 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 clicking here to add American Electric Power.

The final recap

American Electric Power has failed three of the quick tests that would make it a sell. Does it mean you should sell your American Electric Power shares today solely because of this? Not necessarily, but keep your eye on these trends over the coming quarters.

Remember to add American Electric Power 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.