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 me illustrate this with a real-life instance using OSIM International Ltd (SGX: O23). 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
From the above, we can observe that the hard knock OSIM’s stock price had suffered came from a combination of both a falling EPS and PE ratio; the former has shrank by 28% while the latter had declined by 17%.
Given the depth of OSIM’s fall in earnings, its lower share price may be justified.
OSIM has endured back-to-back year-on-year 13% declines in revenue in its past two quarters primarily due to soft market demand. The company, which is perhaps most well-known for its namesake-branded massage chairs and peripherals, also experienced a drastic reduction in free cash flow in the second-quarter of 2015 from $29.7 million a year ago to $8.6 million.
The stock market’s increasing pessimism toward OSIM – reflected in the lower PE ratio – could be in reaction to the company’s recent results.
But that does not mean that all hope’s lost for OSIM. The company still maintains a strong balance sheet with a net cash position of more than $216 million. That capital provides OSIM with the resources to find new avenues of growth and weather the current downturn in its market.
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 OSIM’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.