Value Investing: Price/Earnings Ratio
Price earnings ratios are one of the factors which value investors use to determine the prospects of a company’s stock. Value investing, a concept developed by Benjamin Graham and most famously implemented by Warren Buffett, is an investment strategy where you determine the true worth of a company’s stock and trade it within a certain margin of safety. The P/E ratio, as advocated by Graham, is helps determine the stock has sound basics or has been subject to market speculation.
The P/E ratio is defined as the price which an investor pays for every dollar earned by the company. So, if a company reports $2 in earnings per share while the stock trades at $20, the P/E ratio is 10. In other words, earnings per share multiplied by the P/E ratio gives the stock price. Most finance portals offering stock quotes will automatically give you the P/E ratio along with the quote. If you are wondering where this is leading to, the P/E ratio will help you weed out stocks riding on a speculative wave and identify sound stocks which are temporarily trading below their true worth.
There are two levels of comparisons which you need to do. First, you need to find out the average P/E for the industry, or sector. This is because stocks in different industries float around in different P/E ranges. For example, tech stocks with high growth rates and equity margins, may trade at a P/E significantly higher than manufacturing stocks. Sometimes, an industry will go through a protracted bubble or slump. Therefore, it’s always a good idea to compare the current P/E industry average against the ones form previous years.
Once you have the average P/E for the industry, and determine the viability of an industry for investing into, the next step would be to compare stocks within the same industry. If two comparable stocks are trading at the same price, you can identify which one is more attractive by looking at the earnings per share and calculating the P/E ratio.
Please note that value investing is a vast subject, with books written on it and fine-tuned strategies from multiple experts and investors. You are advised to study more about the subject as also to consult your financial planner.