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 entirely from the deserved-end of the spectrum (investment return), entirely from 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.
We can see how these can be done with super market operator Sheng Siong Group Ltd (SGX: OV8). I have summarised how the company’s EPS (earnings per share), PE ratio, and stock price have changed over the last 12 months:
Source: S&P Global Market Intelligence
As the table illustrates, Sheng Siong’s share price had increased slightly due to its higher EPS. In fact, Sheng Siong’s EPS had climbed at a higher rate than its share price. The faster rise would mean that shares of Sheng Siong have gotten cheaper over the past year as measured by the PE ratio; indeed, the supermarket operator’s PE ratio has fallen by 6.3% as its earnings rose.
2015 was a solid year for Sheng Siong. The retailer saw its EPS rising over 19%. It also increased its dividend per share by 17%. Meanwhile, Sheng Siong’s balance sheet ended the year in good shape with S$126 million in cash and equivalents and no debt.
But, there were some troubled spots as well.
Free cash flow for 2015 came in at negative S$9.2 million. The management team also cited a sluggish economy as a reason for a cautious outlook and commented on the need for the company to rejuvenate some of its older stores. These could be concerns which are keeping the company’s PE ratio a little lower than a year ago.
With a PE ratio of over 20, shares of Sheng Siong do not come cheap. For context, the PE ratio of the SPDR STI ETF (SGX: ES3), an exchange-traded fund which mimics the fundamentals of Singapore’s stock market benchmark, the Straits Times Index (SGX: ^STI), is at 11.6.
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 doesn’t own shares in any companies mentioned.