When you make an investment, you rely on an investment thesis. Why is a particular stock attractive? Is there a catalyst that will improve earnings? Will the company benefit from a changing competitive landscape? Is the valuation compelling?
Being disciplined and considering both fundamental attributes and valuation are essential when investing in stocks.
Being undisciplined and only focusing on fundamentals or on valuation could have negative consequences.
For some "hot" sectors, exuberance and a "fear of missing out" can elevate valuations across the board beyond reasonable levels.
At the same time, there is a difference between buying a stock that is misunderstood or out of favor and buying a stock that is declining in value for a valid reason.
A change in fundamentals will have an impact on your investment thesis. There are many examples of changing fundamentals worth noting including:
• Shifts in the competitive landscape
• Narrowing margins that are long-term in nature
• Regulatory developments
• A long-term impact on inputs
• A new competitor with a sustainable advantage
• Management turnover or turmoil
To detect changes in fundamentals, it is essential to keep up with both company and industry news. Certain financial metrics will also signal a shift in fundamentals -- a significant decline in or negative revenue growth, narrowing margins, declining free cash flow, and rising debt levels.
For every stock, there are a few key valuation metrics to monitor.
• Price/earnings (P/E) and P/E-to-growth ratio. The price earnings ratio is the price of a stock over its earnings per share, which represents what investors are willing to pay for one share of earnings. When you compare a stock's P/E ratio to its long-term earnings growth rate, you have the P/E-to-growth ratio, or the PEG ratio. The PEG ratio is helpful because investors can compare the valuations of companies that are growing at different rates.
• Price/book value per share. Book value is a company's assets less its liabilities. Book value per share is the total book value of a company divided by the number of shares outstanding. The price/book value ratio, or price/book ratio, illustrates how much an investor is willing to pay for one share of a company's book value.
• Dividend yield. Dividends are distributions of earnings to equity shareholders. The dividend yield is annual dividends per share over the price of a share of stock.
• Cash Flow Yield. Earnings per share can include one-time adjustments and other noncash items. Looking at the cash flow yield, you can assess a company's true ability to generate cash.
Free cash flow divided by the total stock market capitalization gives you the free cash flow yield.
You should also consider a stock's valuation relative to both industry peers and the overall market.
If the overall market has had an extended run, you should not only compare a stock to the market valuation metrics, but also to historical valuation multiples for that particular stock.
This is especially true for high beta stocks, where the upside and downside potential are greater.
Sell discipline impacts long-term performance
Investing requires discipline. Never fall in love with an investment.
Try to assess each investment objectively. If you don't exit when your exit strategy calls for it, your investment performance will suffer.
Recognize when it is time to move on. More often than not, investors regret waiting too long to sell a holding rather than exiting too early.
• Nancy Doyle is the founder of The Doyle Group and the author of "Manage Your Financial Life: A Thoughtful and Organized Approach for Women." Visit manageyourfinanciallife.com and follow Nancy Doyle on twitter