Do you like to pay taxes? I doubt it, but taxes are a function of successful investing. Paying a capital gain tax on a profitable trade is part of the game, yet some investors hold on to a stock too long because they don’t want to pay any taxes. In some cases, a stock will drop, eliminating all the profit and capital gains, which is worse than paying taxes. Let’s look at a few examples.
Cisco was the poster child for internet stocks in the late 1990s and early 2000s. From 1995 to March 2000, it soared more than 4,015%, rising from $1.95 to $80.25 – a nice little profit. However, some investors did not sell because they thought it would trade higher, but by October 2002, it dropped by 88%, wiping out capital gains for many investors. At its peak, Cisco traded at a price-to-earnings ratio of 205, or more than 13 times its historical average, and hasn’t eclipsed its all-time high set twenty-three years ago. Cisco Systems initiated a dividend in 2011, long after it corrected.
Disney has fallen on hard times, and the stock is struggling, trading near a nine-year low of $87.18 as issues mount at its theme parks, movie studios, and other outlets like ESPN. At its peak, it sold for more than $200 per share. Over the past decade, Disney traded from $64 per share to $200, gaining 214%. Since March 2021, Disney has fallen 56%. Its PE ratio touched 300 as it started to correct, fifteen times the historical average for Disney. Disney also eliminated its dividend in 2021, another sign it may be time to lock in your profit.
3M has been a financial powerhouse, but the stock has dropped because of pending litigation related to forever chemicals and earplugs. From January 2000 to January 2018, it soared 428% but has since dropped 60%, trading near a ten-year low. At its peak, the PE ratio was 32, which was not significantly overvalued but more than two times its average. The dividend yield dropped to 1.5%, more than half its historical average of 3.9%.
NVIDIA is the current “it” stock because of artificial intelligence and has risen more than 200% this year and more than 12,000% since 2013. It has not given up its gains, and investors are holding on for more. Will it correct like the other stocks? Who knows, time will tell. It trades at a price-to-earnings ratio of 230, or six times its historical average, so it may be wise to lock in some profits. NVIDIA’s dividend yield is .04%, or 60% below its average of .1%.
Of course, selling a stock at its peak is more luck than skill and easier said than done. Hindsight is twenty-twenty. However, do not let your capital gain tax drive your investment decision. It never hurts to realize a profit if the stock valuation is overvalued or extended. I have seen too many investors give up gains to avoid paying taxes.
Once you acquire your stock, calculate your target price so you have a general idea of where to sell it. The PE ratio and dividend yield are two financial metrics you can use to calculate a ballpark range for selling your shares.
- Price-to-earnings ratio. The PE ratio is a common metric for stock valuation. It’s not foolproof; some analysts don’t like it, but it will give you a general idea of the future valuation of your shares. For example, if the historical PE ratio is 20 and the projected earnings per share are $5, the stock valuation is $100 (20 x $5). If your stock is selling for $80, it’s undervalued; if it is selling for $140, it’s overvalued. As the price rises, so does the PE ratio. Do not automatically sell your stock if it hits your price target. Reevaluate it based on new data or information. If nothing changes, consider selling a few shares.
- Dividend Yield. The dividend yield is another financial metric you can use to determine the price target for your stock. For example, if the company pays a $2 dividend and the average dividend yield is 5%, the stock valuation is $40 ($2 divided by .05). It’s undervalued at $30 and overvalued at $50. The dividend yield drops as the price of the stock rises.
Finding historical financial data is relatively easy on Yahoo! Finance, Morningstar, or Value Line. A quick calculation can identify which stocks to sell or buy for your portfolio.
Then Jesus said to them, “Give back to Caesar what is Caesar’s and to God what is God’s.” And they were amazed at him. ~ Mark 12:17
July 23, 2023
Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM’s custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on your asset level.
Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren’t suitable for every investor. Prices and yields are for today only and are subject to change without notice.
Data sources: YCHARTS and Value Line