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 refer 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 refer 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.
Deciphering the fall
We can track the reasons for a stock’s movement by noting down simple but important financial metrics like its earnings per share (EPS) and price to earnings (PE ratio); they could also be a simple way for you to track the progress of a company over time and can form part of your investment journal entries.
Let’s use rig builder and property developer Keppel Corporation Limited (SGX: BN4) as an example. Below, I have summarized the company’s EPS, PE ratio, and the change for each number compared to a year ago:
Source: Google Finance; Earnings Report
As you can see, the 38.4% decrease in Keppel Corporation’s stock price from a year ago was mainly caused by a PE ratio that has declined by 38.3%. Meanwhile, the EPS for Keppel Corporation has actually held up well during the timeframe we’re looking at.
So, why has the stock market grown so much more pessimistic about the shares of Keppel Corporation (as alluded to in the falling PE ratio)?
It should be no surprise by now to know that the impact of lower oil prices has been felt at the oil and gas firm. In Keppel Corporation’s recent quarter (second-quarter of 2015), revenue tumbled by 19.3% year–on-year while the order book sank from $14.1 billion at the end of the second-quarter of 2014 to $11 billion. Moreover, Keppel Corporation’s balance sheet has deteriorated; the company ended the recent quarter with $5.1 billion in net-debt, down significantly from the $3.3 billion in net debt seen a year ago.
These could be the reasons for any negative sentiment that’s weighing down Keppel Corporation’s stock.
But there are positives to note too. Keppel Corporation’s Chief Executive Officer Loh Chin Hua said during the recent earnings briefing that its Offshore and Marine division is planning to deliver 15 rigs this year, followed by eight rigs next year, and six rigs the year after. Repairs may also pick up some of the slack; the repair business will come with lower revenue but a better profit margin.
With all the above in mind, the Foolish investor may be in a better position to judge whether the current pessimism (in the form of a lower PE ratio) for Keppel Corporation’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.