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 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, stock price returns can be from the deserved-end of the spectrum (investment return), the undeserved-end of the spectrum (speculative return), or anywhere in between.
Deciphering The Fall
We can track the reasons for a stock’s movement by noting down simple but important financial metrics like its 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 entries.
We can see how this might work with corporate marketing outfit Kingsmen Creatives. In the table below, I have summarized changes to the company’s EPS, PE ratio, and stock price compared to a year ago:
Source: S&P Capital IQ
As you can tell, a combination of a lower EPS and PE ratio have weighed on Kingsmen Creatives’ stock price, causing a 16.8% drop over the past year.
Kingsmen Creatives’ recent results have not been promising. In the six months ended 30 June 2015, the company’s EPS saw a hefty 38% year-on-year decline.
Slow consumer demand has led to a slowdown in the company’s fit-out services business. Furthermore, Kingsmen Creatives’ interim dividend was also cut from $0.015 per share a year ago to $0.01. These could be reasons why the PE ratio has declined.
It’s not all doom-and-gloom with Kingsmen Creatives however. The company still has a rock solid balance sheet with a net cash position of S$53.5 million as of 30 June 2015.
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 (decline), or whether it is simply a result of investor exuberance (pessimism).
When we understand the difference, we may become a better judge on whether a stock’s price-gains (losses) are justified – with commensurate growth (decline) in earnings – or had happened because of the market’s irrationality. Such knowledge can then aid us in our decision making.