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 vehicle distributor Jardine Cycle & Carriage Ltd (SGX: C07) 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
Jardine C&C’s EPS has declined by more than 18% over the past year.
Meanwhile, its stock price has risen over 56% which indicates that its PE ratio has expanded significantly. This phenomenon may appear strange, as the higher PE ratio suggests that investors are optimistic, even though profits have declined.
The latest half-year results was not great either. Jardine C&C saw both revenue and underlying profits decline 6% and 8% year on year. The management team also sounded a cautious note for the rest of of the year.
The minor bright spot might be the fact that Jardine C&C kept its dividend unchanged.
If a stock price rises (or falls), we should try to find out 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.