When to Consider Buying or Selling Based on News

Bad news hits companies, sectors, and entire markets all the time. But so do bad vibes that aren't associated with a change in the underlying investment. These events can tell you when to sell a stock but also when to buy. The challenge is sorting through the emotions and facts, along with your investment strategy, to decide what to do next.

If the news is just a blip in the company's longer-term story, bad news and stock market turbulence could wind up being a potential buying opportunity. If the company's current news story makes a fundamental change in its underlying outlook, it could indicate that it's time to cut losses and move on.

It's critical for investors to investigate whether the facts have changed, or just the market's mood toward the stock. Markets as a whole often overreact to bad news, and that's where disciplined investors may potentially find value. Unfortunately, individual investors sometimes overreact as well and therefore buy or hold on downturns when the better choice might be selling.

Before deciding when to sell stocks and when to add to a position, an investor has to evaluate the new fundamentals. Have they changed? Does the current stock price reflect that? Does the new price match the new outlook?

When a story crosses the wire, the stock market tends to react to the headline. This often leads to overreaction: If the news appears to be bad, then the stock price tends to drop. It may not be clear if the news is going to get worse, or if it's been announced and already priced in by traders, or if there are more days of volatility expected.

Some questions to consider: What were expectations for the company and its stock before the news hit? Were investors expecting good news, only to be disappointed? Were they expecting bad news and found the news even worse than they feared? Reading stories from investing-related media outlets can help determine how the news is being interpreted by analysts and pundits. The company may have a vested interest in making its financial situation look good through its own press. Outside observers are less likely to have a bias.

A good way to analyze the effect of a news event on a stock is to look at its price-to-earnings (P/E) ratio—the stock price (the "P") divided by the company's annual earnings per share, or EPS, (the "E"). If a stock is trading at $20 per share and its EPS is $1, then the stock has a P/E of 20 ($20/$1). Likewise, if a stock is trading at $20 per share and its annual EPS is $2, then the stock is said to be trading at a P/E of 10 ($20/$2).

P/E ratios can be based on future year earnings estimates (forward P/E) or past results (trailing P/E). After a news event, a trailing P/E will change if the stock price changes. The forward P/E may change based on a price change and a change in earnings estimates for future quarters.

When investors' perception of a stock worsens and they're looking to pay less for a dollar's worth of earnings, P/E contraction occurs. The stock's price falls (even though the EPS remains stable) and the P/E ratio moves lower.

Changes in market conditions or the long-term investment outlook may change the price, the earnings, or the P/E multiple itself. This can be due in part to uncertainty about future earnings and potential shifts that could affect the stock's industry or overall economy. If investors feel future earnings will be underwhelming, a stock's P/E ratio may languish at a relatively low level.

After bad news hits, the stock's market price will most likely fall, further changing the P/E multiple. Investors then need to re-assess if most of the effect is due to expected lower earnings (the "E") or an uncertain or negative outlook (the multiple).

The key is to evaluate whether the current P/E ratio for the stock of a given company is presently "high" or "low" relative to the stock market and the company's fundamentals. The tricky part is that there are no precise definitions for "high" or "low." The best way to assess a company's P/E ratio is by:

1. Comparing the company's current P/E to its historical P/E range
2. If appropriate, comparing the company's current P/E to that of similar companies in the same business or industry group

In general, if the company's current P/E valuation is at the lower end of its historical P/E range or below the average P/E of a similar company, then it may be a potential buying opportunity.

P/E ratios are also calculated for exchange-traded funds (ETFs) and for market and sector indexes. Investors can use this information to evaluate news that affects particular industries or the broader stock market.

It's hard to watch the value of your brokerage account fall due to a news event. It's easy to hope that the market is having a short-term overreaction and that everything will be just fine in the long run. But hope isn't an investment strategy. Both beginners and experienced professionals can be seduced by the idea that the stock market will reward them for their belief in a stock, but that's not what happens.

Analysts at brokerage firms, including Charles Schwab, assign ratings to stocks to help clients with investment decisions. While different firms have different formulas for their ratings, most work with the basics: buy, sell, and hold.

A buy stock is one an analyst thinks you should buy now, a sell is one an analyst thinks you should sell if you already own it, and a hold is one an analyst thinks is good enough to keep in a portfolio but not worthy of additional investment. These ratings are not perfect and are obviously sometimes wrong, but they give investors a sense of what professionals who know the company well think the outlook is after digesting the latest news.

By combining news, a stock's valuation, and analyst ratings, an investor can consider whether it's time to buy, sell, or hold. If the bad news is overdone, the dip could be a great buying opportunity. But this needs to a be a rational decision, not an emotional one.

Bad news can be a potential buying opportunity if the market has already incorporated the bad news into the share price, or if the price has overreacted. Investors need to analyze the news and evaluate the new P/E ratio to determine if it's time to buy. Sometimes, investors are hesitant to sell a losing stock because they don't want to take a capital gain or because they're hoping the news is wrong. Neither reason should be a substitute for impartial analysis.