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:

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.

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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.