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:
Price-earnings ratio = current stock price ÷ current earnings per share
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