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 agri-business juggernaut Wilmar International Limited (SGX: F34) as an example here. The table below (click for larger image) shows how the company’s EPS, PE ratio, and stock price have changed compared to a year ago:
Source: S&P Capital IQ
Wilmar’s 16.4% decline in price was mainly caused by a compressed PE ratio which outweighed a 13% jump in EPS.
As an agri-business conglomerate, Wilmar has four main business segments: Tropical oils (Plantation and Manufacturing), Oilseeds and Grains (Manufacturing and Consumer Products), Sugar (Merchandising, Manufacturing and Consumer Products), and Others.
For the second-quarter of 2015, the firm reported an 11.7% year-on-year fall in its revenue and an 18.2% rise in profit. As of 30 June 2015, Wilmar also had US$1.99 billion in cash and equivalents and US$22.5 billion in borrowings, giving rise to a net debt position of US$$20.5 billion. The lack of top-line growth and the high amount of borrowings may have pressured Wilmar.
Elsewhere, general market malaise – as signified by the Straits Times Index’s (SGX: ^STI) larger-than-20% decline from its 52-week high that was reached in April this year – may also have dragged down Wilmar’s shares.
On the flipside, Wilmar managed to generate US$1.2 billion of positive free cash flow for the first six months of 2015. Consistency of free cash flow would be key here, given the firm’s high level of borrowings.
With all the above, the Foolish investor may be in a better position to judge Wilmar’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.
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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.