Price to Earnings (P/E) ratio

What is price to earnings(P/E)? Well, it is exactly what is claims to be :)

P/E = current price of the stock / earnings per share

We can get the current price from the closing price at the stock exchange.
We can get the earnings per share from the latest financial statement of the company. It is usually part of the Income statement, or put in a separate section. When we get quarterly financial statements, we may extrapolate the quarterly earnings per share over the entire year. This is just an indicator, but it can give us some early warning if the earnings of the company are considerably different than last year.

As far as Value Investing is concerned, Graham has some suggestions. We should buy securities with average P/E less than 25 over the past 7 years, and with P/E less than 20 over the latest reported earnings.

Value Investing Guidelines:

• Average P/E over past 7 years <>
• P/E over latest reported earnings <>
  

We will call this 'Graham Earnings Test'. The averaging helps us select securities that have a good profit history over the past years, but allowing for a bad year in between. The second criteria allows us selecting a company with good current earnings.

The lower the P/E is it can mean 2 things:
1. The security is not overpriced
2. The company earnings are high.

Of course some high growth companies have high P/E as a result of the anticipated growth and the high projected earnings in the future. This doesn't make them a bad choice and their future profits hike may make them a good investing at current time. The 'Graham Earnings Test' is a helpful tool, but as everything in life, it should not be used blindly. The Intelligent Investor should make an intelligent decision for each separate security.

Margin Of Safety

Value investing was first introduced by Ben Graham & David Dodd during their lectures in Columbia Business School in 1928. It was later formulated in the all-time Business Classics 'Security Analysis' and 'The Intelligent Investor'.

The main idea is to do some fundamental securities analysis to find shares that are under priced, meaning trading at price lower than their Net Asset Value.

Graham first introduced the term 'Margin of Safety'. Margin of Safety put simply means buying stocks trading below their tangible book value. This will offer protection to the investor, during the inherent variability and fluctuation of the market. Graham noticed that the market fluctuates continuously and many times violently. Even the best investor cannot know these fluctuations in order to be protected. His only hope is to buy his shares at as low price as possible, and actually at a value less than what a company is worth.

The idea is that if you buy a stock trading below its tangible book value, however violent the market fluctuations are, it will eventually trade at a fair price. A fair price can be the Net Asset Value, or higher depending on various other factors. But if you buy the stock at a high price, you may fall into a downward market before being able to sell it, and can take years to break even.

Put simple: 'The less you pay, the less is your possible loss'

Value Investing

Value Investing was introduced by Benjamin Graham in his all-time classic book 'The Intelligent Investor'. It has been followed by some of the world's greatest investors since, with Warren E. Buffett as the most eminent.

The main idea of Value Investing(VI) is to buy stocks with very good fundamentals, good profit history, in as low price as possible. The ideal pick for Graham was to buy stocks traded with value less than their Net Asset Value, meaning traded less than what they are worth. With relatively simple methods and stock indexes, the investor can select undervalued stocks of good companies. This is usually done during periods of market correction, however as Graham pointed out, there are undervalued stocks at all times.

Graham separated the investors in 2 types, the Passive and the Intelligent. Passive of course doesn't mean not-intelligent. Their main distinction is the time and effort they devote on selecting stocks. A passive investor can have good returns of his investments as well. But as Graham points out, an Intelligent investor that devotes enough effort, can have better than average return than the total market.

The Intelligent investor will get the best stocks at the lowest possible price. When the market valuates the stocks correctly in the future, then the Investor can get a good capital return. In the meantime he will also be receiving good dividend yield, since he bought stocks of profitable companies at a relatively low price.