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SBS Transit Ltd’s Shares Are Mostly Unchanged Over The Past Year: What’s Next?

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 public bus and train services provider SBS Transit Ltd  (SGX: S61) as an example. Below, I have shown how the company’s EPS and PE ratio have changed compared to a year ago:

2015-09 SBS Transit Table

Source: Google Finance; Earnings Report

SBS Transit’s stock price may be largely unchanged, but the same certainly can’t be said for its EPS and PE ratio. As you can tell, the two numbers have expanded by 25% and contracted by 17.9%, respectively.

Looking at the information, it would seem like SBS Transit’s EPS is catching up with the lofty PE ratio that the transport firm was trading at a year ago.

At a current PE ratio of 31.6, SBS Transit can still be considered to be highly valued. For comparison, the SPDR STI ETF (SGX: ES3), an exchange-traded fund mimicking the market barometer, the Straits Times Index (SGX: ^STI), has a PE ratio of just 11.5 at the moment. The market’s optimism for SBS Transit may have been fuelled by the recovery in earnings that the firm had recently put up.

Beyond the elevated PE ratio, there are other areas which may warrant some caution too; as of 30 June 2015, SBS Transit had a sizable $507 million in net debt on its balance sheet. That high level of borrowings adds financial risks.

Foolish takeaway

With all the above in mind, the Foolish investor may be in a better position to judge whether SBS Transit’s current PE ratio is justified.

If a stock’s 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.