Rational Investing: Profit formula simplifies stock-selling decision

Clark Davis is a 34-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company.

"But how do you know when to sell?"

A good question, since most investors' time is spent determining what to buy and at what price. Selling, frequently, is a nondiscipline that is driven more by emotion than logic, resulting in the "buy low-sell high" adage getting reversed.

Let's address it by first recognizing that asset allocation, which calls for rebalancing a portfolio on a regular basis, is not exciting. Asset allocation is rewarding in the long term, but without the rush some get from finding a stock that doubles. So we'll set that aside and address how to sell individual issues.

Regular readers of this column know that we apply a discipline that measures various ratios for individual companies: price to earnings, price to sales, price to earnings to earnings growth rates, etc. We screen a large database for issues that meet our criteria. Those that qualify are further subjected to a series of technical screens based on price, time and volume.

Let's look at just one of the screens we use in selecting what are referred to most often as value stocks those with a strong balance sheet and an estimated takeover value greater than its market price. In this instance, we will look at the buy/sell levels on the basis of the price-to-earnings to growth rate, often called the PEG.

For the purpose of this example we'll assume that we set our screen to select issues that are selling at a price to earnings ratio that is equal to or less than the company's earnings growth rate. Thus, all other screens being met, we could be looking at issues that have an earnings growth rate of 15 percent per year and a price-to-earnings ratio of less than 15 times, perhaps as low as eight or 10 times. To see how any selected issue compares to others in its industry, we also check to see what the PEG is for the industry. If the industry PEG is greater than the PEG for the company, then we have a buy candidate.

So we have set the buy side, now to the sell side. Remember, we are looking to make profits with value issues, not speculating or trying to hit home runs, so we can use a simple approach to setting the price at which we will sell the issue by using a PEG level. Let's say we have chosen to use a PEG of one as our points of reference for selling, meaning we will hold the issue until it sells at a price-to-earnings ratio equal to the stock's growth rate. Secondarily, we will look at setting a sell price based on the industry PEG.

Here's an example, using an issue that we hold for several of our clients (but which we will use purely as an example not a recommendation, since we do not know your risk tolerance.)

Darden Restaurants

Price = $19

Projected 2004 earnings = $1.42

Price/earnings ratio (price divided by earnings) = 13.3

Projected earnings growth rate = 15 percent

PEG = 13.3/15 = .88

Simple PEG = 1x growth rate = 15 price/earnings

Targeted price = Projected earnings times growth rate = 15x1.42 = $21

This exercise produces a conservative price target of $21, a potential return of 10.5 percent. A more aggressive approach is to assign to the issue the industry PEG, producing a much higher price target.

Industry PEG = 1.55

Projected full valuation = industry PEG of 1.55x15 percent growth rate = price to earnings of 23.2 = 1.42x 23.2 = $32.

Now we have produced a very high valuation (a potential 68 percent return) that must be judged in terms of overall market trends. A price-to-earnings ratio in the 20s for a stock growing at a projected 15 percent a year is not uncommon in a well-defined bull market, but should be considered out of the norm in a poorly defined market trend.

Which method would you use? We'll talk about that in the next column.

A cautionary note: Both projected earnings and projected earnings growth rates are variables that must be watched closely. A change in either will impact the targeted price.