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); 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 see how this works with land transport giant Comfortdelgro Corporation Ltd (SGX: C52). The table below shows 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 12.3% increase in Comfortdelgro’s stock price was supported by a 5.5% increase in its EPS and a 6.5% hike in its PE ratio.
Comfortdelgro’s higher PE ratio had come about despite the generally sour market conditions over the past month.
It is possible that investors may have been impressed by the recent 6.7% increase in interim dividend that Comfortdelgro has offered. This dividend-raise comes on the back of the land transport giant’s track record of steady dividend growth over the years; to that point, Comfortdelgro’s payout had increased from $0.055 per share in 2010 to $0.0825 per share in 2014.
It’s not all a bed of roses, though. Comfortdelgro had reported negative free cash flow in the quarter that just past. This may be one area for investors to keep an eye on. Furthermore, shares of the company are also trading at a PE ratio which is at the high-end of its historical trading range.
With all the above in mind, the Foolish investor may be in a better position to judge whether the current 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 (losses) are justified – with commensurate growth (decline) in earnings – or had happened because of the market’s irrationality. 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.