How to calculate when to sell a stock?

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The decision to sell, in many cases, is more challenging than the decision to buy. After all the initial excitement of the potential returns is gone, you are looking at an actual return. Is the return “good enough”? Should I let the stock run some more? How to calculate when to sell as stock? How do we take profits?

We must remember that every company is different, and if we buy a company at a great discount compared to other investments, decisions to sell will change accordingly. That is why in general, I try to avoid rules of thumb when thinking about selling a stock. This does not apply if you have a long term buy-and-hold portfolio with ETFs. There you will be better off making as little moves as possible.

Do not sell based on percentage return

To sell a stock based on realized percentage return is probably the worst advice I ran into on the internet—rules of thumb, like sell when you reach 20-25% return. Sure, 25% return sounds like a decent return, but why that number? It tells me absolutely nothing about the company itself and tells me the price difference between when I purchased it and the price it currently trades at.

Let’s take a slightly absurd example but let’s look at Apple stock over the last five years.

Apple Stock Total Return

Pick a point on the graph and imagine you sold the stock when you achieved some arbitrary return like 25% without considering the company’s long-term potential and future earnings growth. In the example of Apple, you would miss out on 400%+ returns.

Obviously, this is looking at it retrospectively. Everybody is smart when looking at history and thinking I would have done the same but my point is that price of a stock is just one variable in this equation.

Rising stock price doesn’t mean you were right

Imagine you buy a stock, and it keeps rising in price. You are happy and congratulate yourself on the job well done. But behind the stock is a company that becomes dangerously overvalued. Maybe even the company’s fundamentals are deteriorating simultaneously, but hopeful traders keep pushing the stock into new highs.

Were you correct in investing in such a company, or was it actually a bad investment, and the rising price has nothing to do with it. Wait, isn’t the point of investing to make money? Who cares if the company is a lousy business as long as stock is rising in price?

Let’s answer that question with an example of a company called Luckin Coffee.

Here is the deal. Luckin Coffee is a coffee company in China that operates more than 4,500 stores across 40+ cities. You might think this is a very old company with deep roots in coffee sourcing and operations. Well, no, it’s barely four years old.

Company Overview

Luckin Coffee is the pioneer of a technology-driven new retail model to provide coffee and other products of high quality, high affordability, and high convenience to our customers. Our mission is to be part of everyone’s everyday life, starting with coffee.

Okay, you read some more and see words like AI, Machine Learning, Disruption, and so on. As you read, you have to remind yourself that you are not reading about Google or Apple but a coffee shop.

A quick glance at the financials:

  • The company has lost over $244MM in 2018, $457MM in 2019, and $809MM in 2020.
  • Expenses are rising, but so is the revenue, so that’s okay as long as there is growth.
  • $1 billion in liabilities
  • Cash from operations: -$200+MM
  • Cash from investing: -$180+ MM
  • EBITDA (Trailing Twelve Month): -$300+MM

Okay, that is fine. The company is in growth mode. It got enough cash through the Initial Public Offering (IPO), so it is not a problem.

We know that China is not huge on coffee yet as they drink tea, but perhaps the culture is changing. Looking at Starbucks, they are present in China, and Starbucks only has around 4200 stores, but still, that is a significant presence. Maybe this new AI-driven Coffee shop is so much better that is why it has over 4500 stores.

There are also some Fraud allegations, but the management skillfully ignores them.

Here is the 3Y price chart for LK.

Around November 2019, the stock is trading at $18. If we were to invest then, we would be celebrating. Less than three months from our entry, the stock is trading at $50—300%+ annualized rate of return.

But we don’t sell. We think this is just the beginning of a coffee revolution in China so we hold on to our 300%+ profit in hopes it will be 1000%+.

Then the stock drops a little bit; we are not worried; once we have tasted the 300%+ we are sure it will come back, and it does, although not to the same level, so we wait a bit more. Then another small drop, another upswing until March 2020, when the stock finally plummets to $4.

What happened?

The company admits to sales fraud.

Source: https://technode.com/2020/04/03/luckin-coffee-admits-to-sales-fraud/

Were we right to invest because the stock price was rising? No. This would have been a horrible investment regardless of the outcome. There was nothing of value underneath the stock.

Stock price will always revert back to what the company is worth, it might take time, but it will always happen.

We won’t know when to sell with 100% certainty

Unfortunately, we will never know for sure when to sell a stock. As an old saying goes: “Nobody went broke by taking profits.” But it sure sucks looking at the price of a stock rising after you sold it.

So instead of worrying about making perfect sell decisions, we must employ logical strategies.

Create Sell Lists

We have heard of “watch lists” before, but they are typically for companies you want to buy. We can utilize the same strategy for the stocks we own.

Once a company goes on the list, we watch it more carefully than some other holdings. The idea here is to understand whether the company can grow further and whether the current price makes the stock overvalued.

Once the stock has reached valuation levels that we believe are just too high from a fundamental perspective, we lock our profits and sell but necessarily all simultaneously.

We don’t have to close our positions entirely

When deciding when to sell something, we can take our time as we don’t have to sell everything at once. Let’s imagine the stock we bought goes up 5x. By selling half of our position, we get more than double our initial invested capital and let the stock run for a bit longer.

Here is our example with David’s Tea.

Davids Tea Total Return

I have initiated a position in DTEA at $1.05 and sold half of my position at $3. Making 200% return in less than seven months. If I sell everything, that is undoubtedly an incredible return. But I believe David’s Tea has room to grow, so I will keep my position intact.

David’s Tea went through a significant restructuring at the beginning of 2020 that shifted its strategy from retail stores to mainly e-commerce. The remaining retail stores remain profitable. Thanks to the restructuring, gross profit margins remain at the high 40%.

Davids Tea Gross Profit Margin

The company has no debt.

The company is also innovating with CBD-infused teas. Here is what management has to say about growth prospects:

We expect to emerge from CCAA a transformed and radically different organization with a digital-first strategy that required changes to every aspect of our business. Over the past year, we have focused our efforts to find new ways to engage with tea lovers and to replicate our in-store tea discovery experience across multiple digital platforms. But while the way we connect with our customers has evolved, our purpose remains the same. As a leading tea merchant with a strong brand, we seek to share our passion and love for tea, and our unique and innovative blends, with new audiences. We have now laid the foundation to scale and expand our business in a borderless environment both in North America and around the world, and we are excited about the future.

So at this time, I am happy to keep my other half invested. Sitting on cash is not always great, so it is a good idea to know what you might be buying next.

Sell to get into something even better

The perfect situation to be in is when you have a few stocks sitting on your watch list and something incredible comes up. I can take profit without regrets down the line and invest them in something I believe is currently undervalued and is on sale.

Timing is never perfect where I sell one thing and instantly get into something else, but timing will never be perfect, so we have to be okay with that.

Building Cash Position

Inevitably the situation will happen where you would want to sell a big portion of your portfolio, lock in those profits, and there will be nothing on your radar that is good enough to buy.

That may certainly be the case right now, where stocks have reached their all-time high valuations, and everything seems so expensive.

Warren Buffett has that problem; just look at Berkshire’s cash & short-term investments built up over the years. On average, the company is adding $40BN in cash every year from operations as well.

Berkshire Cash position over time

That is a “not so good” problem to have during expensive markets, but a great problem when markets start coming down and good companies start going on sale.

If you are just starting out investing, you have to be a lot more vigilant because risks are higher simply due to high valuations. If you are sitting on a lot of winners and thinking whether to sell them or not, look at their valuations and ask yourself if something better is likely to come along.

Happy Investing!

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