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P/E-based Valuation

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Valuing a stock by the ratio of its current market price and some form of its per share earning of the underlying company.

Some commonly used forms of earnings include earning from the past fiscal year, earning in the previous four fiscal quarters, and expected earning for the current fiscal year.

P/E-based valuation draws on the belief that the value of a stock is backed by the value of the company that issues the stock, and the value of the company is determined by its ability to earn income for its shareholders. The higher income a company can generate for its shareholders, the higher it should be valued.

There are a few known issues with the validity of this method:

  1. Earning is a very imperfect measure of a company's earning power. It only represents a company's performance in one particular period.
  2. Earning can be easily manipulated by company executives.
  3. In some industries earning is not a particularly useful measure of company performance, e.g. insurance, banking, real estate.
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