Graham devotes a complete chapter on how to use the Price to earnings ratio or PE ratio to make stock market decisions. We explain what a PE ratio is, how to calculate it and how to use it. We go through Graham’s examples but also give modern examples of what to watch for when investing.
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PE Ratio Explained - How To Use Price Earnings Ratio For Stock Market Decisions
Good day investors. We continue with our summary on the best investing book out there Benjamin Graham's The Intelligent Investor. Today we're going to talk about Chapter 12 what these price earnings ratio P E ratio and how to use it. GRAHAM First message is don't take a single year's earnings seriously and if you pay attention to short term earnings look out for booby traps in the per share earnings I would add here also a quote from the book. It is too much to expect that most shareholders can relate all their common stock decisions to their long term record and long term prospects. So let's start with what is a price earnings ratio the price earnings ratios the ratio of the company's stock price and the reported yearly earnings usually of the last four quarters trailing price earnings ratio. For example Facebook's stock price is 200. Earnings per share are six price earnings ratio is two hundred divided by six. It is for the free point free. Now Graham is focusing on real and adjusted earnings current and long term averages. Average earnings and dilution so we'll go to Graham's example I'll give you some modern examples of what to watch when using price earnings ratio for investment decisions. Let's start Gramps example is Alcoa the aluminum producer and earnings in 1970 1969 have been pretty stable. As you can see here reported were 520 and 558. The stock price was around 60 so the price to earnings ratio was around 12 which is not bad but look at what happens when those are adjusted. Something still going on today. It's even a bigger scale.
So primary earnings but then we have net income per share after special charges fully diluted fully diluted after a special charges. So Alcoa had convertible preferred debt which can be converted into shares which means new investors will come on board. So reported primary earnings were 520 in 1970 but actual earnings were for 19. And this thing keeps going on now even more than it was the case in the past just for the quarter. You can see okay those who focus on quarterly earnings would see Alcoa back in 1970 how it had one point fifty six in Q1 1961 one point fifty eight in Q1 1970 which means that it is doing better. But after special charges adjusted real earnings were 70 cents compared to 158 in the 1970s. So Graham's message here is to always look for real earnings and not the topline reported earnings. Management always reports better.