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 ratio (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 SembCorp Marine Ltd (SGX: S51) 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: Google Finance; Earnings Report
As you can see, the 38% decrease in SembCorp Marine’s stock price was mainly caused by a PE ratio which has gone lower by 33% from where it was a year ago. In comparison, the decrease in EPS for SembCorp Marine was ‘just’ 8% over the same timeframe.
From the above, it would appear that the stock market has become increasingly pessimistic about SembCorp Marine’s prospects. But why is the stock market pessimistic?
This could be similar to what we saw with Keppel Corporation Limited (SGX: BN4). The impact of lower oil prices had been felt at SembCorp Marine as well. In SembCorp Marine’s latest quarter, its revenue dropped by 10% year-on-year while its orderbook fell 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.
Adding fuel to fire, SembCorp Marine ended 30 June 2015 with $1.7 billion in net debt on its balance sheet; the rig builder’s balance sheet has weakened significantly compared to a year ago when it had net-debt of ‘only’ $880 million.
As another possible signal of stress, SembCorp Marine’s interim dividend had also been cut from five cents per share a year ago to four cents per share.
These could be the reasons for the stock market’s sour feelings for SembCorp Marine.
In light of the bleak outlook for the oil & gas industry, SembCorp Marine’s management team is looking to shore up its balance sheet in order to tide over rough times.
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 SembCorp Marine’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 (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.