In our everyday life we sometimes wonder about the most basic question of stock market – why does the price of a share go up or down? We are not talking about the daily or weekly gyrations but in the long run why the stocks moves.

The two most basic reasons are:

• Change in earnings
• Re-rating and De-rating of PE ratio

Let us see the net effect on the stock price when we combine these two phenomenon.

PE Re-Rating

Suppose we have a new company in its supernormal growth stage and is delivering a growth of 50% p.a. The market is not sure of its sustainability and since it’s a new stock the number of analysts covering this stock is low. The market due to all these factors assigns a PE of 20 to this stock. If the EPS this year is Rs. 10, the stock would trade at Rs. 200.

Suppose next year also the stock continued its growth momentum and posted a growth of 50%. The EPS in this case would be Rs. 15. The market now recognises this stock as quarter after quarter it is posting impressive growth; also more analysts start analysing this stock. As the awareness increases the market thinks and due to its consistency and earning potential rerates the PE to 40. The stock price would then rise to Rs. 600.

The change of Rs. 400 (600-200) in stock price or trebling could be attributed to 50% change in earnings but the major part 100% is due to PE expansion.

PE De-Rating

When the stock keeps on delivering higher growth returns the PE attributed to the stocks are higher. Remember the hay days of Infosys, it was traded at more than 100 PE multiple, it kept on delivering doubling of returns and kept the market happy. But once the base becomes bigger and since there is no entry barrier in the industry the PE ratio is now languishing at 15-17, which is its long term growth rate now.

Continuing with above example let us assume that due to competition and base effect the growth rate falls to more manageable level of 20%. The market acknowledges the fact that the days of super growth are over and assigns a PE of 20 now. The EPS would be now Rs. 18. (120%*15), and the stock would fall to Rs. 360.

The stock comes down by 60% due to PE contraction or de-rating and goes up by 20% due to Earnings Growth; the net effect would be a fall of 40%.

One caveat needed to be mentioned here – PE ratio is determined not only by growth in earnings but a lot more factors like visibility and stability of earnings, corporate governance, regulatory and macro scenario, etc.