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 aircraft maintenance, repair, and overhaul (MRO) firm SIA Engineering Company Ltd (SGX: S59) as an example here. The table below shows how the company’s share price, EPS, and PE ratio have changed compared to a year ago:
Source: S&P Capital IQ
Despite having a higher PE ratio, SIA Engineering’s share price had still suffered because of a sharply lower EPS. .
In its last completed quarter, the MRO firm reported lower revenue as well as a 42% year-on-year plunge in its share of profits from associated companies and joint ventures. This number typically makes up about half of SIA Engineering’s pre-tax profit; as such any declines there can have significant impacts to SIA Engineering’s overall bottom-line.
A similar scenario of declining business activity is seen at Singapore Technologies Engineering Ltd’s (SGX: S63) aerospace segment, which is a competitor to SIA Engineering; the segment’s top-line had declined by 4% year-on-year as well over the same period.
But, investors might be happy to note that the balance sheet for SIA Engineering remains solid with more than S$454 million in net cash (S$488.1 million in cash and just S$33.7 million in debt) as of end-June 2015. SIA Engineering’s strong balance sheets gives it a higher chance of tiding over tough times as well as of finding new avenues for growth.
With all the above in mind, the Foolish investor may be in a better position to judge SIA Engineering’s future.
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.
If you'd like to receive investing insights and be updated on the latest company and stock market news, sign up for a FREE subscription to The Motley Fool's weekly investing newsletter, Take Stock Singapore.
Also, like us on Facebook to follow our latest hot articles. The Motley Fool's purpose is to help the world invest, better.
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.