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.
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