ARA Asset Management Limited’s Shares Have Fallen By 26.3% In A 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 real estate fund management outfit ARA Asset Management Limited  (SGX: D1R) as an example. Below, I have summarized how the company’s EPS, PE ratio, and stock price have changed compared to a year ago:

2015-10 ARA Table

Source: Google Finance; Earnings Report

ARA Asset Management’s stock price has dropped a painful 26.3% over the past year and as you can tell, it has happened mainly because of a sharp reduction (29%) in its PE ratio. In contrast, its EPS had climbed slightly by 4.2%.

The EPS growth has to be taken into context though. ARA Asset Management’s recent results were not promising. Quarterly revenue and EPS saw declines of 9% and 21% year-on-year respectively.

Meanwhile, the firm’s balance sheet had also weakened due to the purchase of a strategic stake in Suntec Real Estate Investment Trust (SGX: T82U), a REIT that it manages. As of 30 June 2015, ARA Asset Management had reported a net debt position of $49.3 million, a sharp reversal from the net cash position of $24.8 million as of 30 June 2014.

On the flip side, ARA Asset Management has had a commendable long-term history of generating increasing levels of free cash flow and subsequently, rising dividends.

Foolish takeaway

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 a stock’s 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 owns shares in Suntec REIT and ARA Asset Management.