Motley Fool: July 21, 2012

Posted: July 21, 2012 - 12:35am

Ask the Fool

Selling Triggers

Q: How do you know when it’s time to sell a stock? — E.M., Syracuse, N.Y.

A: Your ultimate results depend on the price at which you bought and sold a stock, so selling at a sensible time is critical. Consider selling if you’ve found a significantly more promising place to put your money. (If you find only a slightly more attractive place, the tax hit on any capital gains might wipe out the value of moving your money, unless the stock is in an IRA.)

You might also sell if the stock is now significantly overpriced or if the reason you bought the stock is no longer valid. (Perhaps the company has made some boneheaded moves, and you no longer have confidence in management, for example. Or maybe competitors are eating the company’s lunch.)

Selling is also smart if you’ll need the money within three to five years. Such short-term money shouldn’t be in stocks in the first place.

Other selling triggers include if you don’t know much about the company, if you can’t remember why you bought it, if you’re just holding for emotional reasons, or if you can’t explain how it makes its money. Whenever you buy a stock, consider jotting down the reasons why you did and when you might sell. Then refer back to that paper periodically.

Q: Do you have a step-by-step guide to investing? — P.N., Lake Charles, La.

The price-to-earnings (P/E) ratio can give you a clue as to whether a stock is undervalued or overvalued. It’s a measure that compares a company’s stock price to its earnings per share (EPS), usually for the previous 12 months. Think of it as a fraction, with the stock price on top and the EPS on the bottom. Divide the stock’s price by EPS, and voila — the P/E. The ratio is calculated for you at many online stock research sites, such as finance.yahoo.com.

Imagine that Sisyphus Transport Corp. (ticker: UPDWN) is trading at $20 per share. If its EPS for the last year (adding up the last four quarters reported) is $1, just divide $20 by $1, and you’ll get a P/E ratio of 20.

Note that if the EPS rises and the stock price stays steady, the P/E will fall — and vice versa. For example, a stock price of $20 and an EPS of $2 yield a P/E of 10. (In stock-talk jargon, you might say that such a stock is “trading at a multiple of 10.”)

You can calculate P/E ratios based on EPS for last year, this year or future years. Published P/E ratios generally reflect past performance. Intelligent investors should really focus on future prospects by calculating forward-looking P/E ratios. Simply divide the current stock price by the coming years’ expected EPS. Compare a company’s current P/E to its historical range, too.

Many investors seek stocks with low P/E ratios, as they can indicate beaten-down companies that may rebound. But remember that a low-P/E stock can always fall further. And don’t just fall for a seemingly low P/E, as P/Es vary by industry. Car manufacturers and banks typically have low P/Es (often in the single digits), while software and Internet-related companies command higher ones (often north of 30).

Don’t stop your research with a stock’s P/E. There are many other numbers to examine when studying a stock — such as its sales and earnings growth rates, debt level and profit margins. Compare companies to their competitors, too.

My Dumbest Investment

The Wrong Time for GE

My dumbest investments have been buying General Electric at $32.50 and watching it plunge to $6.50, and setting sell limits too high in 2000 and watching some stocks go to zero. — B.A., Hilton Head Island, S.C.

The Fool responds: Those who bought GE in the $30s have indeed been burned, but if they’ve hung on, their losses (which are not yet realized, since they haven’t sold) have shrunk. The stock was recently trading around $20. The company’s future is promising, too, as it invests in alternative energies and its core businesses. Its GE Capital unit, which got whacked in the recent credit crisis, has turned itself around and will resume paying dividends to the parent company. GE’s stock has sported a dividend yield above 3 percent lately, too.

With GE and also with your setting sell limits too high, your errors might have been avoided if you’d tried to determine what your various stocks were really worth. With overvalued ones, consider selling or not buying, or be prepared for a dip in the price. If you’re planning to hold great companies for decades, simply expect temporary downturns.

Foolish Trivia

Name That Company

Founded in 1991 and based in California, I’m the world’s largest “fabless” semiconductor company, meaning that I design and market chips, while outsourcing their manufacturing. I rake in more than $7 billion annually, and nearly 100 percent of Internet traffic passes through at least one of my chips. I employ 10,000 people, three-quarters of whom are engineers. My products deliver voice, video, data and multimedia connectivity in the home, office and mobile realms. I’ve bought nearly 50 companies in the past 20 years. My intellectual property portfolio features 16,800 foreign and U.S. patents and applications. Who am I?

Last Week’s Trivia Answer

Based in Burbank, Calif., I was founded in 1923 and have grown into a top global entertainment company. I operate the ABC television network, ESPN, SOAPnet, theme parks, water parks, resort hotels, a cruise line, Hyperion Books, Hollywood Records, Touchstone Pictures and much more. I own a chunk of A&E/Lifetime networks, as well. You may associate me with lions and rodents and ducks. I bought the Muppets in 2004, Pixar in 2006 and Marvel in 2009. I issued my first stock in 1940. It has gained about 8 percent, on average, annually over the past 20 years. Who am I? (Answer: Walt Disney)

It’s a market leader in an emerging technology, with only one serious competitor at the moment, Stratasys (Nasdaq: SSYS), which recently merged with Objet, 3-D printing’s third major player. 3D’s revenue, net income and free cash flow have all been trending solidly upward.

3D Systems is making a major push for the home user. Its plug-and-play printer and community model is the first of its kind. The Cube (and its Cubify.com community) is similar to Hewlett-Packard’s successful razor-and-blade-style printers-and-ink model. Scale matters with such a model, though, so 3D Systems will need to appeal to more than the hobbyists.

The company’s other products and services encompass medical uses, aerospace applications and more, and its service revenues are increasing at a rapid clip.

With big potential comes big risks, and 3D Systems is not risk-free. Profit margin has been shrinking recently, and the company remains largely dependent on corporate clients such as automakers or defense contractors, which are facing tough times of their own.

3D Systems isn’t cheap, but it might reward long-term investors. (The Fool owns shares of 3D Systems, and its newsletters have recommended it and Stratasys.)