You bought a stock at what you thought was a good price. Some time later, you check the price and realize the stock has fallen to well below what you paid for it. Now what? Do you sell at a loss or hold on in hopes of a rebound?
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If you find yourself in this unfortunate situation, be encouraged by the fact that you’re not alone. All active investors — even the best and most famous — have been there. If you own equities you will see drawdowns, it’s an unpleasant but inevitable reality.
The first piece of advice, if you’re holding a stock that’s showing an unexpected, unrealized loss, is simple: Don’t beat yourself up over the situation and don’t give up on investing in the markets. Stocks have an excellent history of appreciating over time, but not all investments work out and even stocks that go up don’t go straight up. Enduring periods of depreciation and taking occasional losses when necessary is a painful but important part of the process.
Before explaining when to sell a stock at a loss, you should first understand when not to. Don’t sell out of fear, anger or emotion. It’s natural to be emotional about your hard-earned money, but important financial decisions should be made with a clear head and be based on hard facts.
Here are some good reasons you might want to sell a stock at a loss:
— Changes in company fundamentals
— Changes in earnings
— Changes in revenue
— Debt levels
— Changes in dividends
Changes in Company Fundamentals
When you hear Wall Street analysts or financial pundits talk about a stock’s fundamentals, they’re referring to the foundational financial facts that can propel a company to success or drive it to failure. A stock’s fundamentals are measures of the company’s success and the stock’s valuation, and can be seen through various ratios investment ratios as well as changes in factors like debt, revenue and earnings per share.
It’s easy for investors to keep track of fundamentals because publicly traded U.S. companies are required to publish their financials at least quarterly, and may have to make supplemental reports if there are drastic changes in the meantime. The quarterly earnings reports are also known as earnings releases and contain a wealth of information. Wall Street and the financial media constantly monitor earnings releases and will report good news and bad news as soon as they get it.
If a stock goes down but nothing has fundamentally changed with the company, it may be nothing to worry about. It could be a normal sell-off, it could be a bad day, week or month in the market, or it could be nervous traders overreacting to some negative headline that might prove to be trivial. The point is that if a stock’s fundamentals have not changed, the mere fact that a stock is down is not a reason to dump it. Conversely, if a company’s big-picture outlook does change, you may want to rethink your position.
This article takes a look at four fundamentally important things to track: earnings, revenue, debt and dividends. If these four indicators are deteriorating, then selling for a loss may be justified.
Changes in Earnings
One of the most important fundamentals to keep an eye on is earnings. A company’s earnings are reported as earnings per share, or EPS, and are arguably the primary element investors use to determine a stock’s fair market value.
If a company reports disappointing earnings and is unable to explain how the shortfall happened and how it’s going to correct the situation, it could be a dangerous sign. In some cases it’s a sound reason to sell a stock that’s down. It’s helpful to know the dates of upcoming earnings releases and pay attention to the financial news when those reports come out.
When one of your stocks disappoints on the earnings front, watch what Wall Street does. If analysts are adjusting their future earnings estimates downward and issuing downgrades and asset managers are selling, you may want to consider selling as well.
It’s important to remember that Wall Street is an expectations game, and that stock values are, at least in theory, based on expected future results. That often makes a company’s guidance for the quarter or year ahead more important than whether the company met expectations last quarter. Often companies will exceed expectations when they report earnings but will issue unexpectedly poor guidance — in almost every case, this will cause a stock to justifiably fall.
Over the long run, and in aggregate, stock prices strongly correlate with earnings growth. So if earnings start to trend sideways or down, it may be time to get out.
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Changes in Revenue
Revenue is another vital metric to watch when evaluating a company’s success, and changes in revenue should be taken into consideration when deciding whether to sell a stock at a loss.
In general, the term “revenue” can be thought of as a slightly fancier way to say “sales.” While there are subtle differences between the two terms — revenue is all the money a company takes in in a given period, while sales is the money generated from selling its goods or services — they are often more or less interchangeable.
Revenue, also known as “the top line” due to its position on the income statement, is obviously a vital figure for investors to track. It’s possible for revenue to fall and earnings to go up if margins grow, or conversely for revenue to rise and earnings to fall, but growing revenue over time is vital because it represents the absolute limits for how much a company can earn. You’ll never reach $1 billion in earnings if you never make $1 billion in revenue first.
Falling revenue, and even decelerating revenue growth, can be signs to sell a stock, depending on how enduring such trends are and what stage of its life cycle a company finds itself in.
Debt Levels
When used prudently, debt is a valuable tool companies can utilize to raise capital and conduct business. When misused, debt can be dangerous and can hurt a stock’s valuation. From an investor’s standpoint, debt is something to watch closely. Troubling debt can be a reason to sell.
Increasing debt levels, when viewed in relation to cash flow, earnings and equity, can be an unwelcomed indication of financial stress. A company with high debt levels is usually more vulnerable to downward market moves than other companies with better balance sheets.
Watch the debt levels of the stocks you own. If the debt is growing and they’re being forced to borrow at higher interest rates, it may be better in the long run to take a loss and deploy your capital elsewhere. Debt rating agencies like Moody’s, Fitch Ratings and S&P can be excellent resources. If you see these major firms issue credit downgrades, it means they see the company as more likely to default on its debt, and it may be time to sell.
Again, there are good reasons to raise debt. But high levels of debt, as evidenced by an elevated debt-to-equity ratio of above 1.0, can be a red flag. The rationale for high debt can vary from sector to sector and industry to industry, so be sure to compare a company’s debt levels to its peers.
Changes in Dividends
When assessing a company’s financial health, regular dividend distributions are a good sign. Consistent dividend increases are an even better sign. On the other hand, when a company cuts or suspends its dividend it should give investors pause. In fact, this is often a telltale sign to sell.
A rising dividend is a company’s declaration of confidence in itself. By growing the dividend, a company’s board of directors is telling investors that they can afford to give a portion of earnings back to the shareholder.
A dividend cut shows the opposite. A cut in income distributions is a clear message of financial strain. If a stock you own is down, you might want to hold on to it if the company is committed to paying and growing its dividend. A dividend decrease or cancellation? Consider running for the hills.
Here’s why: Dividends, once instituted, are expected to be paid out every quarter like clockwork — theoretically in perpetuity. That means companies consider very carefully their dividend policies, because once you start paying it, a decision to decrease or cancel it is a disastrous signal to investors.
Keep in mind that some companies — typically energy stocks — pay “special dividends” that can fluctuate wildly based on a company’s earnings in a certain period. It’s not the end of the world if these fluctuate up and down, that’s just how it goes. Also, when talking about dividends rising or falling, you want to look at the quarterly dividend per share paid, not the dividend yield. The dividend yield will naturally gyrate with the stock’s price, while the quarterly dividend is an absolute measure.
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When to Sell Stocks at a Loss originally appeared on usnews.com
Update 02/23/24: This story was previously published at an earlier date and has been updated with new information.
