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.
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); these numbers could also be a simple way for you to track the progress of a company over time and can form part of your entries for your investment journal.
Let’s use utility and marine giant SembCorp Industries Limited (SGX: U96) as an example. I have summarized the company’s EPS, PE ratio, and the change for each number compared to a year ago:
Source: Google Finance; company’s earnings report
As you can see, the 34% decrease in SembCorp Industries’ stock price over the past 12 months was mainly caused by a declining PE ratio; the valuation metric had fallen by 31% from where it was a year ago while the EPS had dipped by only 5%.
From this, it would appear that the stock market has grown increasingly pessimistic on the firm’s prospects. So, why is SembCorp Industries not feeling the love from the market?
It should not be too surprising to learn that the impact of lower oil prices has been felt at the marine segment of SembCorp Industries. In the latest quarter, revenue from its subsidiary SembCorp Marine Ltd (SGX: S51) came down by 10% year-on-year while the order book sank from $12.7 billion at the end of the second-quarter of 2014 to $10.9 billion at the end of the second-quarter of 2015.
Furthermore, SembCorp Industries’ profit in the latest quarter also included a one-off divestment gain of $54.7 million from the sale of a stake in the company’s SembCorp Bournemouth Water Investment. This had boosted SembCorp Industries’ EPS in the second-quarter of 2015.
Elsewhere, SembCorp Industries ended the second-quarter of 2015 with $4.1 billion in net-debt on its balance sheet, down significantly from the $51 million in net-debt seen a year ago.
These could be the reasons for the stock market’s pessimistic feelings for SembCorp Industries.
But, SembCorp Industries’ overseas utility businesses, especially in India and China, are beginning to ramp up. This could help drive growth and may be where Foolish investors would want to keep their eyes on.
With all the above in mind, investors may be in a better position to judge whether the current pessimism (in the form of a lower PE ratio) for SembCorp Industries’ 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 (losses) are justified – with commensurate growth (decline) in earnings – or had happened because of moments of irrationality from the stock market. Such knowledge can then aid us in our decision making while investing.
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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.