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 engineering firm Singapore Technologies Engineering Ltd (SGX: S63) as an example. In the table below, I have shown how the company’s EPS and PE ratio have changed compared to a year ago:
Source: Google Finance; Earnings Report
ST Engineering’s 20% decrease in stock price was caused by the combination of a decline in both its PE ratio and EPS compared to a year ago. The former slipped by 12% while the latter fell by 9.5%.
Given the numbers, it’s perhaps fair to say that the fall in ST Engineering’s shares is partly justified by the lower earnings.
ST Engineering has its fingers in many pies as alluded to by its main business segments: Aerospace, Electronics, Land Systems, and Marine. In the recent quarter, the Marine segment saw its revenue get cut by more than a quarter year-on-year. Meanwhile, ST Engineering’s overall order book fell from $13.4 billion at end-June 2014 to $12.4 billion at end-June 2015.
At the moment, ST Engineering’s business seems to be holding up better than other conglomerates like Keppel Corporation Limited (SGX: BN4) or SembCorp Industries Limited (SGX: U96). ST Engineering’s Electronics and Land Systems segments both saw 8% year-on-year growth in revenue the recent quarter, while the Marine segment posted a 20% increase in profits before tax despite the lower revenue.
ST Engineering’s balance sheet also looks all right given that it had $1.1 billion in cash and equivalents as of 30 June 2015 and nearly the same amount in debt.
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 ST Engineering’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.
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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.