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. 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…
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.
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 on the deserved-end of the spectrum (investment return), the undeserved-end of the spectrum (speculative return), or anywhere in between.
Deciphering the moving pieces
We can track the reasons for a stock’s movement by noting down financial metrics like 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 airline maintenance operator SIA Engineering Company Ltd (SGX: S59) 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
SIA Engineering’s EPS had spiked over 94% over the past year.
The stock price has risen less than 1% which indicates that its PE ratio has shrunk as a result. At first glance, this phenomenon may appear strange, as the lower PE ratio suggests that investors are less keen even though profits grew strongly over the last year.
But there is a good reason why the stock price has not risen in tandem with its surging earnings.
In SIA Engineering’s latest reporting quarter, revenue was down 2.1% year on year. Profits were up almost five-fold to S$198.4 million. However, the bulk of the increase came from a one-off gain of S$178 million from the sale of Hong Kong Aero Engine Services (HAESL). Excluding the gain, profit figure would have been S$20.4 million, a sharp fall from the S$41.3 million recorded in the same quarter a year ago.
The outlook does not look promising at the moment. The SIA Engineering management team expects the challenging operating environment to persist.
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 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.