Close

Introduction to Stock Valuation: The Price-Earnings Ratio

by Joe Lan, CFA

Value investing is one of the most popular forms of long-term investing, trumpeted by such famous investors as Benjamin Graham and Warren Buffett (not to mention countless others).

The premise of value investing is to find stocks that are trading at a discount to their intrinsic value, which, admittedly, is far more difficult than it sounds. Valuation ratios are intended to help investors with this task, providing a metric to gauge the valuation of a company compared to an underlying fundamental data element. In this article, we examine the price-earnings (P/E) ratio, which is the most commonly used measure of valuation.

Throughout the course of our Financial Statement Analysis series, we looked closely at financial statements and ratios to gauge the financial strength of companies. However, no matter how financially strong or fast-growing a firm is, if the stock is not a good value, investors should think twice before purchasing shares. The price-earnings ratio helps investors assess the valuation of a firm. The ratio is calculated by dividing a company’s current stock price by its current earnings per share. It represents the number of times earnings the stock is trading at. Put another way, it shows how much investors are paying for each dollar of earnings per share. The formula is presented as:

...To continue reading this article you must be registered with AAII.

Gain exclusive access to this article and all of the member benefits and investment education AAII offers.
JOIN TODAY for just $29.
Register for FREE
to read this article and receive access to future AAII.com articles.

Log in
Already registered with AAII? Login to read the rest of this article.
  
Joe Lan, CFA is a financial analyst at AAII.


Discussion

William Gammage from Louisiana posted 7 months ago:

Helpful!


Prem Jindal from Pennsylvania posted 7 months ago:

How does the P/B RATO COMPARE WITH P/E AS MEASURE OF VALUE VERSUS GROWTH


Ronald Dunnington from Pennsylvania posted 7 months ago:

How about some snapshots of periods in the past that would show the probability of success given selected strategies.


John Wiley from Arizona posted 7 months ago:

Do you have a recommendation is to which forward earnings estimates are the most reliable? Here's the copy/paste of the column headings from the latest S&P index download.

OPERATING AS REPORTED OPERATING
EARNINGS EARNINGS EARNINGS
PER SHR PER SHR PER SHR
(ests are (ests are (ests are
bottom up) top down) top down)


You need to log in as a registered AAII user before commenting.
Create an account

Log In