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Wednesday, November 17, 2010

Should you sell Harley-Davidson (NYSE: HOG)

Currently Trading 25 X's 2010 earnings estimate
Do fundamentals matter in the U.S. Stock Market?

By Jeremy Phillips
The Motley Fool

The decision to sell a stock you've researched and followed for months or years is never easy. If you fall in love with your stock holdings, you risk becoming vulnerable to confirmation bias -- listening only to information that supports your theories, and rejecting any contradictions.

In 2004, longtime Fool Bill Mann called confirmation bias one of the most dangerous components of investing. This warning has helped my own personal investing throughout the Great Recession. Now, I want to help you identify potential sell signs on popular stocks within our 4-million-strong Fool.com community.

Today I'm laser-focused on Harley-Davidson, ready to evaluate its price, valuation, margins, and liquidity. Let's get started!

Don't sell on price
Over the past 12 months, Harley-Davidson has risen 30.8%, versus an S and P 500 return of 11.3%. Investors in Harley-Davidson have every reason to be proud of their returns, but is it time to take some off the top? Not necessarily. Short-term outperformance alone is not a sell sign. The market may be just beginning to realize the true, intrinsic value of Harley-Davidson. For historical context, let's compare Harley-Davidson's recent price to its 52-week and five-year highs. I've also included a few other businesses in the same or related industries

Potential sell signs
First up, we'll get a rough idea of Harley-Davidson's valuation. I'm comparing Harley-Davidson's recent P/E ratio of 56.3 to where it's been over the past five years
Source: Capital IQ, a division of Standard & Poor's
Harley-Davidson's P/E is significantly higher than its five-year average, which could indicate the stock is overvalued. A high P/E isn't always a bad sign, since the company's growth prospects may also be increasing alongside the market's valuation. However, it definitely indicates that, on a purely historical basis, Harley-Davidson looks expensive.
Now, let's look at the gross margins trend, which represents the amount of profit a company makes for each $1 in sales, after deducting all costs directly related to that sale. A deteriorating gross margin over time can indicate that competition has forced the company to lower prices, that it can't control costs, or that its whole industry's facing tough times. Here is Harley-Davidson's gross margin over the past five years

Source: Capital IQ, a division of Standard & Poor's
Harley-Davidson is clearly having issues maintaining its gross margin, which tends to dictate a company's overall profitability. Harley-Davidson investors need to keep an eye on this troubling trend over the coming quarters.
Here, short interest is at a high 9.4%. This typically indicates that large institutional investors are betting against the stock.
Now, let's study Harley-Davidson's debt situation, with a little help from the debt-to-equity ratio. This metric tells us how much debt the company's taken on, relative to its overall capital structure

Source: Capital IQ, a division of Standard & Poor's

Harley-Davidson's debt has spiked over the past five years. When we take into account decreasing total equity over the same time period, this has caused debt-to-equity to increase, as seen in the above chart. Based on the trend alone, that's a bad sign. I consider a debt-to-equity ratio below 50% to be healthy, though it varies by industry. Harley-Davidson is currently above this level, at 306.2%.
The last metric I like to look at is the current ratio, which lets investors judge a company's short-term liquidity. If Harley-Davidson had to convert its current assets to cash in one year, how many times over could the company cover its liabilities? As of the last filing, Harley-Davidson has a current ratio of 1.93. This is a healthy sign. I like to see companies with current ratios greater than 1.5.
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