It’s hard to let go of winning stocks – typically, they keep winning because the businesses behind them are great. It takes discipline to take some profits off the table.
The folks at Altfest Personal Wealth Management, a New York City advisory firm, understand this. “There’s a lot to like about Apple (AAPL),” says investment strategist and portfolio manager Mayukh Poddar. “It’s a great business, its balance sheet is good, and it dominates its market.” But in 2019, the firm began to reduce its holdings in the stock because it had become “quite expensive” on a variety of measures.
Figuring out if a stock is overpriced requires some work. You must develop a sense of what a business is worth, based on financial statements, the strength of its brand and the competition. It’s the kind of analysis that investors should do before they buy a stock, but often don’t, says Christian Koch, a CFP based in Atlanta.
At a minimum, if a stock price is soaring, make sure that revenues and earnings are still increasing at a commensurate pace. The price-earnings (P/E) ratio is a popular gauge of how expensive a stock is relative to other stocks or to the broad market. The S&P 500 Index currently trades at a P/E of 21, based on estimated earnings for the year ahead.
Stock sectors have their own idiosyncrasies – financials trade at an average of 14 times earnings currently; tech trades at 24. Individual stocks can vary even more. A stock’s high P/E might be justifiable, and a low-P/E stock might be no bargain, so it’s important to consider other factors and other financial measures, such as the ratio of price to sales or price to book value (assets minus liabilities). An annual downward trend in any of these measures could signal a shift in the company’s fortunes.
Some investors set a target – say, a 30% gain – and take their winnings when the goal is reached. That’s not a bad strategy, says Ellis. “You never lose if you take a profit,” she says.