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 run this through with telecommunications outfit StarHub Ltd (SGX: CC3). The table below shows how StarHub’s EPS, PE ratio, and stock price have changed compared to a year ago:
Source: Google Finance; Earnings Report
As you can see, the 14% decrease in StarHub’s stock price over the past year was mainly caused by a 13.6% contraction in its PE ratio. The telco’s EPS on the other hand, had slipped ever-so-slightly by only 0.4% over the same timeframe.
From the above, it would appear that the stock market has become more pessimistic on StarHub’s future prospects.
One reason for the pessimism could be the possible entry of a fourth telco into the Singapore market. Furthermore, the balance sheet for StarHub has weakened and is currently sporting a net-debt position of around $533 million as of the end of June this year (this is a big step down from the $463 million in net-debt that was reported for the end of March this year).
These could be the reasons for the stock market’s dour feelings for the telco.
Elsewhere, the Straits Times Index (SGX: ^STI) is also down around 20% from its peak in April this year, signifying some general malaise in the stock market. StarHub may have been dragged down by the negativity too.
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 StarHub’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.