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, a stock’s price return can be made out entirely of the investment return component, entirely of the speculative return component, or a mixture of both components.
Deciphering the movement
We can track the investment or speculative components of a stock’s return by noting down changes in its financial metrics such as its earnings per share (EPS) and price to earnings ratio (PE ratio). On a related side note, such notes 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.
Over the past year, supermarket operator Sheng Siong Group Ltd (SGX: OV8) has seen its shares rise by 24%. Let’s see what Dorsey’s framework can tell us about the company’s share price movement. In the table below, I have summarized how Sheng Siong’s EPS and PE ratio have changed over the past year:
Source: Google Finance; company’s earnings reports
We can see that Sheng Siong’s shares have risen from a combination of EPS growth and PE expansion. The company’s EPS registered a healthy 16% increase compared to a year ago while its PE climbed slightly from 24.2 to 26.0.
Sheng Siong managed to grow in its latest reporting quarter (the second-quarter of 2016). The retailer’s EPS rose 11% in the second quarter and it increased its interim dividend per share by 8.5%. Sheng Siong also ended the quarter with a clean balance sheet that had $51 million in cash and equivalents and no debt.
To be sure, it’s not all rosy. Free cash flow for the second quarter of 2016 came in at a negative $37.2 million. At a PE ratio of around 26, Sheng Siong’s shares are also trading above the market’s PE. Regarding the market’s PE, the SPDR STI ETF (SGX: ES3), an exchange-traded fund which mimics the fundamentals of the Straits Times Index (SGX: ^STI), is valued at under 11.9 times trailing earnings as of 14 September 2016.
If a stock price rises (or falls), we should try to understand if it is backed by a company’s fundamental growth (or decline), or whether it is simply a result of investor exuberance (or 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 something that happened because of luck or the market’s irrationality. Such knowledge can help us with our decision making.
For more stock analyses and investing tips, sign up here for your FREE subscription to The Motley Fool's weekly investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.
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.