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 use telecommunications firm Singapore Telecommunications Ltd (SGX: Z74) – also know as Singtel – as an example. In the table below, you can see how the company’s EPS and PE ratio have changed compared to a year ago:
Source: Google Finance; Earnings Report
Singtel’s stock price may be largely unchanged, but it’s a different story when it comes to its PE ratio and EPS. The former has fallen by 12%, as you can tell, while the latter has gained 11.9%.
Unlike its peers Starhub Ltd (SGX: CC3) and M1 Ltd (SGX: B2F) (see here and here), which have seen their share prices get cut largely as a result of a flat EPS and shrinking PE ratio, Singtel’s EPS growth had cancelled out its falling PE ratio.
With the numbers we’ve seen, the stock market appears to have grown more pessimistic about Singtel’s prospects despite its decent earnings growth.
The possible entry of a fourth telco into the Singapore market may be cause for some concern. Meanwhile, Singtel’s weaker balance sheet may also have spooked the market; the telco’s net-debt position of S$6.5 billion on 30 June 2014 has climbed to S$7.3 billion as of 30 June 2015.
Elsewhere, general market malaise – as signified by the Straits Times Index’s (SGX: ^STI) near-20% decline from its 52-week high that was reached in April this year – may also have dragged down Singtel’s shares.
Notably, Singtel’s business goes beyond Singapore. For the financial year ended 31 March 2015, 31% of Singtel’s free cash flow came from its associates and joint ventures located in countries like India, Philippines, Indonesia, and Thailand.
The other countries where Singtel has an interest in may provide additional avenues for future growth outside of Singapore and also help mitigate some of the risks which may come from new competitors in the Singapore telecommunications 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 Singtel’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.