There can be good reasons as well as poor reasons for why a stock’s price moves. For the Foolish investor, understanding the right reason is important. If we can determine the reason, we may get an inkling on whether the movement in the stock price is deserved or undeserved and thus act accordingly. A simple framework To help with this, I would like to defer to a couple of paragraphs from The Little Book that Builds Wealth by author and fund manager Pat Dorsey: “Over long stretches of time, there are just two things that push a stock up or down: The investment return, driven by…
There can be good reasons as well as poor reasons for why a stock’s price moves.
For the Foolish investor, understanding the right reason is important. If we can determine the reason, we may get an inkling on whether the movement in the stock price is deserved or undeserved and thus act accordingly.
A simple framework
To help with this, I would like to defer to a couple of paragraphs from The Little Book that Builds Wealth by author and fund manager Pat Dorsey:
“Over long stretches of time, there are just two things that push a stock up or down: The investment return, driven by earnings growth and dividends, and the speculative return, driven by changes in the price-earnings (P/E) ratio.
Think of the investment return as reflecting a company’s financial performance, and the speculative return as reflecting the exuberance or pessimism of other investors.”
Under Dorsey’s framework, stock price returns can be from the deserved-end of the spectrum (investment return), the undeserved-end of the spectrum (speculative return), or anywhere in between.
As an example, consider a company with a stock price of $1.00 with an earnings per share (EPS) of 10 cents and a price to earnings (PE) ratio of 10. Here are two extreme scenarios for how the stock price can increase from $1.00 to $2.00:
- In the first case, the change in the stock price came from an increase in the EPS from 10 cents to 20 cents with the PE ratio remaining unchanged at 10.
- Alternatively, the stock price could also rise to $2.00 if the EPS remains at 10 cents while the PE ratio expands from 10 to 20.
In the first case, we could argue that the rise in stock price was more justified as it is backed by the company’s EPS growth.
In the second case where the EPS was unchanged, the rise in the stock price would be down to the stock market awarding a higher earnings multiple to the company. This would represent a shakier proposition as to whether the rise in the stock price is actually sustainable.
Keeping a journal
We can track the reasons for a stock’s movement by noting down simple but important financial metrics like the EPS and PE ratio; they could also be a simple way for you to track the progress of a company over time and can form a crucial part of your investment journal.
Let’s use land transport giant Comfortdelgro Corporation Ltd (SGX: C52) as an example. Below, I have summarized the company’s EPS, PE ratio and the change for each element compared to a year ago:
Source: S&P Capital IQ
As you can see, the 19.9% increase in Comfortdelgro’s stock price had mostly been backed by a market which has awarded the land transport outfit’s stock with a higher PE multiple.
A potential reason for the optimism could be the new bus contracting model that the Singapore government has introduced where bus companies will have to bid for the rights to operate certain bus routes. While Comfortdelgro – through its SBS Transit Ltd (SGX: S61) subsidiary – didn’t win the first package of bus routes on offer, there are another two bus service packages that are up for grabs.
With that in mind, the Foolish investor may be in a better position to judge whether the brighter optimism (in the form of a higher PE ratio) for Comfortdelgro’s future is justified.
If a stock price rises (or falls), we should try to understand if it is backed by a company’s fundamental growth (decline), or whether it is simply a result of investor exuberance (pessimism).
When we understand the difference, we may become a better judge on whether our stock price gains are justified – with commensurate growth in earnings – or just a gift from the stock market. While luck is always welcome, Foolish investors could be better off with the former over the long-term.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.