Why Have SATS Ltd’s Shares Risen by 30% in A Year?

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 a stock’s 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 change  

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, shares of airline caterer SATS Ltd  (SGX: S58) have climbed by 30%. What’s happening here?

In the table below, I have summarized changes to the company’s EPS, PE ratio, and share price that have taken place over the last 12 months:

Source: Google Finance; company’s earnings report

SATS’s share price has grown due to a combination of a higher EPS and PE expansion. The company’s EPS registered a healthy 15.4% increase compared to a year ago. Its PE expanded by nearly 12% over the same period. The higher PE ratio could be a sign that the stock market has become more optimistic about the company.

In SATS’s latest reporting quarter (the three months ended 30 June 2016), its EPS rose by nearly 29%. The company also ended the quarter with a net cash position of over $440 million on its balance sheet.

To be sure, it’s not all rosy.

At a PE ratio of 24.4, SATS’s shares are pricier than the market average. To this point, the PE ratio of the SPDR STI ETF (SGX: ES3), an exchange-traded fund which mimics the fundamentals of the Straits Times Index (SGX: ^STI), is around 12 as of 20 September 2016.

Foolish takeaway

If a stock’s 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 our stock’s price gains (losses) are justified – with commensurate growth (decline) in earnings – or something that happened because of the market’s irrationality. Such knowledge can help us with 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.