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 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 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 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 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 integrated resort and casino operator Genting Singapore PLC (SGX: G13) 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
Genting Singapore’s EPS has fallen off a cliff over the past year, plunging over 87% year on year.
Interestingly, the stock price has risen 3.3% which indicates that its PE ratio has risen sharply. This phenomenon may appear strange, as the higher PE ratio suggests that investors are optimistic with the company even though profits have fallen off a cliff.
There wasn’t a lot to cheer in Genting Singapore’s latest reporting quarter . The casino operator’s revenue was down 17% year on year, while profit attributable to shareholders was in the negative zone.
However, there might be some clues to why Genting Singapore’s shares is holding is own.
Genting Singapore is on track to open its integrated resort in Jeju, Korea in 2017’s fourth quarter. The full development is several magnitudes larger in terms of land area, compared to its Singapore operations.
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.