Using the price-earnings ratio to value a stock

What is a price-earnings ratio or (P/E) ratio?

Using the price-earnings ratio to value a stock investors have long considered this (also known as the (P/E) ratio for short) a useful metric for evaluating the corresponding attractiveness of a certain company’s stock price. This theory was made popular by Benjamin Graham, who was dubbed the “Father of Value Investing”Graham preached the virtues of this financial ratio as one of the quickest and easiest ways to determine if a stock is trading on an investment or a analytical basis. Keep in mind as you learn about how to use the (P/E) ratio, there is many more factors that go into trading a certain stock. There are some significant limitations if you were just to use a price-earnings ratio, partly due to accounting rules estimates many investors just predict out of thin air when guessing future growth rates.  Regardless, it is something you should know by heart to better help you evaluate a stock.

Simply put, the (P/E) ratio is the price an investor is paying for $1 of a company’s earnings or profit. In other words, if a company is reporting diluted earnings per share of $2 and the stock is selling at $40 per share, the p/e ratio is 20 ($40 per share divided by $2 earnings per share = 10 p/e).

This can be very useful because, if you invert the (P/E) ratio and divide it by 2.  This is how you can also determine the yield of the stock. Also remember, just because a stock is cheap does not mean you should buy it. Many investors prefer the PEG Ratio instead, because it is also factoring in the growth rate of the security.  Even better is the dividend adjusted PEG ratio because this will take the basic price-earnings ratio and adapt it for both the growth rate and the dividend yield of the stock.  Please stay tuned as I will be letting you know more important factors throughout.  Also I will be showing you how to take all these factors into account and improve your portfolio by knowing when to get into a stock at a certain price and when to get out.