INVESTORS USE PRICE/EARNINGS RATIOS TO PICK STOCKS

The price/earnings ratio is the tool most commonly used to help investors value stocks. Calculated by dividing a firm's per-share market price by its earnings per share, the P/E ratio can identify some attractive buys and eliminate some overpriced stocks from your consideration.

One caveat: although the formula is very simple to calculate, there are many factors that influence either a firm's earnings or its stock price. It is very important to do a thorough analysis of these two components before relying on the P/E ratio. Once you have an accurate P/E ratio for a firm, it is always a good idea to compare it to those of competitors and the price/earnings ratio of the overall market.

If you are interested in learning more about this topic as well as other topics regarding security selection, please consult the other tutorials in this series.