By: musicwhiz Basically, the premise is simple: a company reports a fall in profits due to rising costs and inability to raise prices sufficiently to offset these costs. To add to their woes, staff and admin costs have also increased and put a further strain on net profits. This would of course lead to lower profits in subsequent quarters and the company may see its net profit contract by about 40-50%. The problem is that when this happens, the growth multiple assigned to a company (called the valuation metric or Price-Earnings Ratio - PER) will also correspondingly fall because of lower expectations for growth. This can be clearly seen in the cases of some China companies which had been trading at valuations of 20-25x during the bull market. In today's bear market, with falling profits and limited prospects for growth in market share and margins, analysts are valuing it at a measly 5-6x PER. Thus, the effect of these 2 events causes a severe share price devaluation due to anticipated lower profits as well as putting a screeching halt to growth expectations. This scenario is best illustrated with an example (as shown below):- Read more...