Selling common stock because of overvaluations

Stock overvaluations occur from time particularly in the latter stages of bull markets when average P/E ratios are high by historical standards.

It is at these times that a further reason to sell or part-sell some stocks may arise.

Making money selling stocks places you in a better positions to take advantage of resulting downturns that inevitably follow.

Selling stocks short, or shorting stocks, may be an alternative method of protecting your portfolio from a downturn without having to sell the physical stock itself. This avoids setting up a potential capital gains event.

Do I short stocks? No. I prefer to keep my investing as uncomplicated as possible and prefer to part sell if I am becoming nervous.

How does one recognise an overvalued stock? THe simplest way might be to see if the stock is priced at a historical high for the year. This can be easily seen by viewing a price chart available from online stock-brokers' websites.

However, depending on the fortunes of the particular company and when they have previously announced an earnings result, the high price may reflect a large increase in earnings which has the effect of reducing the P/E ratio.

So while overvaluations may appear to be reflected in price, a particular stock may well be reasonably priced based on its recent performance.

A more appropriate relative valuation guide would be to look at the P/E ratio.

If the price of the stock has run ahead of its earnings because the market has fallen in love with it, this will be reflected in a high P/E ratio.

However, a high P/E ratio for one stock may be quite different from (or relative to) the high P/E for another depending on the industry sector to which they belong.

Hence three P/E comparisons are more useful ... one with its own historical annual average P/E, one with the current average for its sector, and one with the current average P/E for the market as a whole.

I find it instructive to look at the P/E variation (P/E high and low) for a stock for the current year and also the last couple of years. Stockmarket advice in this regard is available to me from a provider selling stockmarket information.

Alternatively you can calculate high and low P/E ratios for a stock by dividing the high and low prices each year from the price chart by the earnings per share for that year.

Selling a stock at or near the high P/E ensures you are getting better value for that earnings period

... and I continue to be amazed (and I am not sure why!) that there is so much variation in the P/E of some stocks. Mr Market is not a logical beast.

Why buy a stock when its P/E is above its average variation for the year when you can hang around (probably for less that a year) and buy it near its historical P/E low?

Note that I have said 'some stocks'. Banks are probably a good example of a class of stocks that have a limited variation in P/E - unless of course they have happened to have done something stupid during the year - which happens.

THEN THERE MIGHT BE A BUYING OPPORTUNITY!

There are other stocks whose high and low P/Es bounce around from one year to the next. This makes it somewhat difficult to use the relative valuation method with these stocks.

Of course another means of discovering overvaluations to see whether you should be selling your stocks is to use one or more of the quantitative valuation methods described in some of the investing books I have reviewed.

This can involve a lot more time unless you are prepared to pay a provider to do the calculations for you.

I prefer the absolute valuation methodology outlined in Brian McNivan's book. I refer to it as an absolute valuation approach as it does not use the share price to determine the stock value - unlike using P/E ratios which obviously do.

Ignoring stock overvaluations can lead to underperformance of your portfolio if, in a resulting downturn, significant value is wiped off your stock holdings - or if you failed to start part-selling soon enough.

Markets have been known not to recover to their previous highs for periods of up to ten years .. and as they say, time is money!

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