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These stocks look overpriced and could tumble

An age old problem for investors is if or when they should sell a company that might be doing everything right but whose stock price has run far, far ahead of what they consider to be a reasonable valuation.

Some investors have strict criteria they keep to. These criteria can include beginning to sell stock as it approached their target price and completely exiting the position once it reaches the target price. Meanwhile, other investors may give a stock some leeway and continue to hold a stock even if it trades above their target price, preferring to own a slightly overpriced, great business than not own it at all. But what do you do if a stock goes well above your target price to trade at levels you consider offer no margin of safety and potentially significant downside risk should the market stop ascribing the lofty multiple to your stock?

It’s a tough decision but when it comes to portfolio management, adhering to a margin of safety when purchasing a stock is equally as important as selling if you believe a stock has significant downside risk.

The following three companies are all high quality businesses and understandably popular with investors, however after gains ranging from around 40% to 70% in the past year – compared with a rise of just 8.6% in the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) – the stock prices of the following three firms are starting to look a little stretched.

Shareholders in diversified telco TPG Telecom Ltd (ASX: TPM) have seen their share price soar 66% in the last 12 months. With the stock now trading on a forecast FY 2015 price-to-earnings (PE) ratio of 22.5, shareholders will need to be convinced that TPG can continue to produce very strong growth rates over the next few years.

Shareholders in education provider Navitas Limited (ASX: NVT) have also enjoyed a surge in its share price with a gain of 39% over the past 12months. The stock now trades on a hefty forward PE of 27.7.

Domino’s Pizza Enterprises Ltd. (ASX: DMP) has been a stellar long-term performer for shareholders. In the past 12 months alone the share price has gained 53% as the company has reported strong earnings growth and expansion. Whether Domino’s can continue to grow earnings at these historic rates and justify a FY 2015 PE multiple of 31.5 though, is what shareholders need to consider.

Foolish takeaway

While the multiples ascribed to the above three stocks could well be justified if each company is able to sustain prior growth rates over the next few years, if any were to report growth rates lower than the market is expecting, then their stock price could fall significantly as investors mark down their valuation premiums.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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