There can be good reasons as well as less good reasons why a stock price moves. For the Foolish investor, understanding the right reason is important. If we can determine the reason, we may get an inkling as to whether the movement in the stock price is deserved. 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…
There can be good reasons as well as less good reasons why a stock price moves.
For the Foolish investor, understanding the right reason is important. If we can determine the reason, we may get an inkling as to whether the movement in the stock price is deserved.
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 fall into the deserved-end of the spectrum (investment return), the undeserved-end of the spectrum (speculative return), or somewhere in-between.
Deciphering the moving parts
We can track the reasons for a stock’s movement by noting down financial metrics such as the 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 .
Let’s use media giant Singapore Press Holdings (SGX: T39) as an example.
Below, I have summarized the company’s EPS, PE ratio and the change for each figure compared to a year ago:
Source: Google Finance; Earnings Report
SPH’s EPS had fallen 26% over the past year.
The stock price is relatively unchanged, which would mean its PE ratio has risen as a result. Unfortunately, the latest reporting quarter wasn’t promising.
SPH’ revenue dipped by 5% while profit tanked 46.4% year on year. However, SPH left its interim dividend unchanged for the financial year ending 31 August 2016 (FY 2016).
Investors might want to be vigilant as changes might be coming for SPH.
In the latest quarter, chief executive Alan Chan said that SPH will be conducting a comprehensive review of its core media business. Investors might want to look out for the changes that will be announced by management.
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 as to whether our stock price gains are justified – with commensurate growth in earnings – or something we should investigate further.
While luck is always welcome, Foolish investors could be better off with the former over the long-term.
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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.