Price-to-Earnings Ratio (P/E Ratio) and Value Investing

When we analyze a company’s fundamentals, we often come across the P/E Ratio, which is also displayed in the fundamentals section on BestStock AI.

But have you ever wondered when the P/E Ratio was first proposed? What problem was it intended to solve? And how exactly should you interpret the P/E Ratio? This article will explain these questions.

The History of P/E Ratio

The concept of the P/E Ratio can be traced back to the early 20th century, but there is no clear record of who invented it. It emerged with the development of financial markets. In 1934, Benjamin Graham and David Dodd introduced the P/E Ratio into the investment analysis framework in their published book “Security Analysis,”beginning its widespread use.

Graham is the founder and father of value investing theory. The philosophy and methodology of value investing come almost entirely from Graham’s writings and practices. Warren Buffett is his most famous student.

After reading Graham’s “The Intelligent Investor” in 1949, Buffett was deeply inspired. He went on to attend Columbia Business School, where he took Graham’s courses, and worked as an investment analyst for Graham’s company, Graham-Newman Corporation, for a period of time.

During Graham’s era, the stock market was highly speculative, and many investors lacked effective tools for evaluating company value. Early investors often relied on fundamental and technical analysis, combined with their own experience and intuition, to purchase stocks. This investment approach was not very reliable, which is why the concept of the price-to-earnings ratio came into focus.

The P/E ratio can help investors assess whether a company’s market price is reasonable, and its measurement method is:the price investors pay for each unit of earnings. Investors can use the P/E ratio to compare the relative value of different stocks, thereby quickly determining whether a stock is overpriced or underpriced.

If the above explanation seems too formal, you can also think of the P/E ratio as the “payback period” — that is, how many years it takes for an investor to recoup their investment cost through the company’s earnings. Graham advocated finding stocks with low P/E ratios, believing these stocks might be undervalued by the market and have investment potential. Based on this philosophy, Graham developed the “cigar butt” strategy (buying stocks of companies on the brink of bankruptcy at extremely low prices).

Buffett initially strictly followed Graham’s “cigar butt” strategy, but later under the influence of Charlie Munger, he gradually shifted to buying excellent companies at reasonable prices, placing greater emphasis on quality and long-term growth potential. He believed that buying excellent companies at reasonable prices is better than buying mediocre companies at extremely low prices.

The History of Value Investing

The popularity of the P/E ratio is inseparable from Graham’s books, which actually laid the foundation for what we now commonly refer to as value investment theory.

In the 1930s and 1940s, Graham developed and systematized the principles of value investing, and his “Security Analysis” (co-authored with David Dodd) and “The Intelligent Investor” are hailed as the bibles of value investing.

Graham proposed the core ideas of value investing, including:

• Intrinsic Value: The intrinsic value of a stock is its true value, which may not equal its market price. Value investors need to assess intrinsic value by analyzing factors such as the company’s financial statements and industry prospects.

• Margin of Safety: When purchasing stocks, ensure the buying price is significantly below the intrinsic value to account for potential future errors in judgment or market fluctuations.

• View stocks as company ownership: Investors should analyze stocks as if they were buying the entire company, focusing on the company’s fundamentals rather than short-term market fluctuations.

• Mr. Market: Graham used “Mr. Market” to metaphorically describe the market’s emotional and irrational nature. Value investors should take advantage of Mr. Market’s emotional fluctuations, buying when the market is down and selling when it becomes overheated.

In a nutshell, value investing is buying stocks at a price below their intrinsic value and holding them long-term until the value is realized.

Value investing remains the mainstream investment approach today, but it’s not a blind adherence to Graham’s philosophy. Many people have their own interpretations of value investing, but the core principles — buying assets with high intrinsic value and viewing stocks as ownership in companies — have remained unchanged.

The History of Modern Investment Theory

Modern Portfolio Theory (MPT).

We can see that value investing was proposed by Graham and then popularized by Buffett and others. Its core is to find undervalued stocks by the market and profit when prices revert to their intrinsic value. However, it still feels somewhat empirical without strong mathematical support. It emphasizes researching a company thoroughly before buying and holding for the long term, but your research may be subjective and one-sided, which is why people like Buffett are rare.

Are there investment theories with strong mathematical and logical support? Yes, there is: Modern Portfolio Theory.

In 1952,Harry Markowitz(who passed away on June 22, 2023 in San Diego, California, USA)San Diegopublished a paper titled “Portfolio Selection,” proposing the concept ofmean-variance optimization, which laid the foundation for modern investment theory. On this basis, the Capital Asset Pricing Model (CAPM), Efficient Market Hypothesis (EMH), Arbitrage Pricing Theory (APT), and others were successively developed, forming a systematic theoretical framework.

Markowitz is known as the father of modern portfolio theory, but unlike Buffett, who is characterized by long-term high-performance returns, Markowitz’s contribution was primarily academic theory rather than actual investment performance. He once established an investment management company, but it mainly provided investment consulting services. His theoretical research earned him the Nobel Prize in Economics in 1990.

Modern investment theory also has several important figures who proposed significant ideas, which will not be elaborated on in this article but will be mentioned in subsequent posts if needed.

Value Investment Theory VS Modern Investment Theory

Value Investing and Modern Portfolio Theory are two different investment philosophies and approaches, but they are not completely opposed to each other; rather, they can complement each other. For clarity, let’s summarize the core ideas of both Value Investing and Modern Portfolio Theory.

The Core Ideas of Value Investing

• Origin: Value investing was introduced by Benjamin Graham and David Dodd in the 1930s and later popularized by Warren Buffett and others.

• Core concept: Find undervalued stocks (stocks whose market price is below their intrinsic value) and profit when the price reverts to intrinsic value.

• Methodology:

  • Fundamental analysis: In-depth research of fundamental factors such as company financial statements, profitability, and competitive advantages.

  • Margin of Safety: Buying at a price below intrinsic value to provide a safety cushion for the investment.

  • Long-term Holding: Focus on the long-term development of the company, rather than short-term market fluctuations.

  • Market Assumption: Believes that markets are not always efficient, and prices may deviate from intrinsic value, thereby creating opportunities for value investors.

The Core Ideas of Modern Investment Theory

• Origin: Modern portfolio theory was proposed by Harry Markowitz in 1952, and later developed into theories such as the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH).

• Core concept: Construct investment portfolios through diversification and optimization of risk and return, rather than focusing on individual assets.

• Methodology:

  • Mean-variance optimization: maximizing returns for a given level of risk, or minimizing risk for a given level of returns.

  • Systematic risk: Focus on undiversifiable risk (beta coefficient) rather than the unsystematic risk of individual stocks.

  • Efficient Market Hypothesis: The theory that market prices already incorporate all available information, making it impossible for investors to achieve excess returns through information analysis.

  • Market assumption: The market is efficient, and prices reflect all available information.

The Relationship Between Value Investing and Modern Portfolio Theory

Common ground

• Shared goals: Both aim to achieve long-term investment returns, helping investors obtain higher returns with controllable risk.

• Risk Management: Value investing reduces risk through a “margin of safety,” while modern investment theory reduces risk through “diversification.”

• Based on fundamentals: Value investing relies on fundamental analysis, while asset pricing models in modern investment theory (such as CAPM) also need to consider a company’s fundamental factors (such as profitability, growth potential).

Difference

Feature	Value Investing	Modern Portfolio Theory (MPT)
Core Focus	Relationship between intrinsic value and market price	Optimization of overall portfolio risk and return
Market Efficiency Assumption	Markets are not fully efficient; prices may deviate from value	Markets are efficient; prices reflect all available information
Investment Strategy	Buy undervalued stocks and hold for the long term	Build an optimal portfolio through diversification
Risk Measurement	Margin of safety and fundamental risk of individual stocks	Systematic risk (beta) and portfolio-level risk
Methodology	Fundamental analysis and qualitative judgment	Mathematical models and statistical analysis
Representative Figures	Benjamin Graham, Warren Buffett	Harry Markowitz, William Sharpe, Eugene Fama

What is Earnings Per Share (EPS)

Above, we discussed the history of the P/E Ratio and then introduced value investing and Modern Portfolio Theory (MPT), but how exactly is the P/E Ratio calculated?

First, there are actually many types of P/E Ratios, but they all work on the same principle. The variety comes from using different data periods, such as using data from the past 12 months or estimates for the next 12 months. However, to understand how it’s specifically calculated, we need to clarify the concept of Earnings Per Share (EPS).

EPS, as its name suggests, is the net profit you receive for each share of a company you own. It is clearly used to measure a company’s profitability. Generally, a higher EPS indicates that the company is better at making money for its shareholders. However, some companies may use accounting techniques to make their EPS appear high while the company is not actually very profitable.

When companies release their financial statements, they provide EPS, typically in the income statement, which directly shows basic EPS and diluted EPS. That’s right, there are mainly two types of EPS, and their calculation methods are similar.

• Basic EPS = Net Income Attributable to Common Shareholders / Weighted Average Number of Common Shares Outstanding;

Meanwhile:

• Net Income Attributable to Common Shareholders = Net Income of the Company — Preferred Stock Dividends

Let me explain these concepts. Finance is like this — the concepts can be convoluted, but they’re actually conventional approaches packaged into concepts for simplified expression.

The concept of common stock is relative to that of preferred stock. In reality, when ordinary people buy and sell on trading platforms, they are most likely common shareholders. Preferred stock typically requires opening a preferred stock trading service with a broker, which most mainstream brokers offer. The stock codes for preferred shares differ from those of common shares; for example, JPMorgan Chase’s common stock code is JPM, while its preferred stock codes are JPM Pr A or JPM Pr B.

Preferred stocks have their own complexities, as different companies may have varying dividend and redemption terms. Additionally, preferred stocks typically have lower trading volumes and less liquidity than common stocks, which is why most people don’t invest in them.

Returning to Basic EPS, it’s essentially that a company’s net income must first minus the preferred stock dividends of senior shareholders, and what remains is the net income for common stock, which is then divided by the weighted average number of common shares outstanding for the period.

Many articles only calculate the current number of common shares, which is not rigorous enough, because companies may issue new shares or repurchase some shares during the reporting period, causing the number of outstanding shares to change. In this case, calculating using a weighted average would be more rigorous. However, typically speaking, whether to use a weighted average or not, the calculated values won’t differ significantly.

Now that we understand Basic EPS, let’s continue with Diluted EPS = (Net Income Attributable to Common Shareholders + Potential Increase in Net Income from Convertible Securities — Preferred Stock Dividends) / (Weighted Average Number of Common Shares Outstanding during the Period + Weighted Average Number of Additional Potential Common Shares).

Diluted EPS is more conservative than Basic EPS because it takes into account the potential dilution effect of shares. The term “potential” means that dilution may not actually occur, depending on specific numerical values. The factor causing these changes isconvertible securities(securities that can be converted into common stock, such as convertible bonds, convertible preferred stock, stock options, etc.).

Diluted earnings per share considers what impact would be on EPS if all these convertible securities were converted into common stock. If the conversion would decrease EPS, it is considered to have a dilutive effect; otherwise, it is not included in the calculation.

Let’s take NVDA’s recent Q2 2026 earnings report as an example. We can find this 10-Q report in the fundamental section of the NVDA stock page on BestStock AI, where Net Income per share is essentially EPS. Although the terminology differs, they refer to the same metric. Some companies’ financial reports use Net Income per share (net profit per share), while others use Earnings Per Share (EPS).

As can be seen from the chart, NVDA provided Basic EPS of $1.08 and also Diluted EPS, which is also $1.08. If we continue to examine this financial report, we will find that NVDA has no preferred stock, as shown in the figure below:

Therefore, when calculating EPS, it is not necessary to deduct preferred stock dividends from net income.

• Basic Earnings Per Share (Basic EPS) = (Net Profit — Preferred Dividends) / Weighted Average Number of Common Shares

  • Since there are no preferred stock dividends, Basic Earnings per Share = Net Profit / Weighted Average Number of Common Shares

  • 26,422 / 24,366 = $1.08

Similarly, in NVDA’s latest financial report, there was no mention of any convertible bonds data, so we would assume it has no convertible bonds. In this case, the calculation of Diluted EPS simplifies to be the same as Basic EPS, which is also $1.08.

How to calculate the P/E Ratio?

Once you understand EPS, calculating the P/E Ratio becomes quite straightforward. Although there are many types of P/E Ratios due to different calculation methods, they are all quite similar. Let me list them one by one:

• Trailing P/E Ratio = Current Market Price of the Stock / Earnings per Share (EPS) for the Most Recent Complete Fiscal Year.

  • Advantages: It uses actual profit data that has already occurred, making it relatively objective and reliable.

  • Disadvantages: It reflects past situations and maynot accurately reflect the company’s future profitability. Suitable for companies with relatively stable profits and little fluctuation. Low update frequency, typically updated once a year when the company releases its new annual financial report.

• Forward P/E Ratio = Current Market Price of the Stock / Expected Earnings per Share (EPS) for the Next 12 Months

  • Advantages: It reflects market expectations for the company’s future profitability and has a forward-looking nature.

  • Disadvantages: Relies on analysts’ forecasts of future earnings, which may contain bias,and accuracy is highly dependent on the quality of forecasts. Suitable for high-growth companies.

• TTM P/E Ratio = Current Market Price of the Stock / Earnings per Share (EPS) for the Last 4 Quarters

  • TTM (Trailing Twelve Months) although literally meaning the past 12 months, it emphasizes using data from the most recent four quarters.It has a higher update frequency, updated every quarter when companies release new quarterly financial reports.

• Adjusted P/E Ratio = Current Market Price of the Stock / Adjusted Earnings Per Share (EPS)

  • Sometimes, a company’s profit data may be affected by somenon-recurring items, such as one-time gains from asset sales or large litigation settlements.The adjusted P/E ratio eliminates the impact of non-recurring gains and losses, better reflecting the company’s sustainable operating capacity. The calculation method needs to be adjusted based on specific circumstances and is relatively complex.

• Cyclically Adjusted Price-to-Earnings Ratio (CAPE Ratio / Shiller P/E Ratio) = Current Market Price of the Stock / Average Earnings per Share (EPS) over the Past 10 Years Adjusted for Inflation

  • Proposed by economist Robert Shiller,it aims to eliminate the impact of economic cycles on the price-to-earnings ratio and is more suitable for long-term investment decisionsto assess the overall valuation level of the stock market.

On trading platforms, Static P/E Ratio and TTM P/E Ratio are quite common, but these two can easily be misunderstood. Some articles state that the Static P/E Ratio is calculated using EPS from the past 12 months, and TTM (Trailing Twelve Months) literally translates to “past 12 months” in English, which can cause confusion. Let me clarify this here.

The static P/E ratio isdata from the past fiscal year, for example, if it’s May 2025 now, then the data you use to calculate the static P/E comes from the 2024 annual financial report (exactly 12 months)

The TTM P/E Ratio is calculated using financial statement data from the past 4 quarters, which happens to be a 12-month period, hence it’s called “past 12 months.” However, it’s not the most recent 12 months. If you interpret it as the most recent 12 months, then for example, if it’s currently May, and the latest financial report was released 3 months ago with the next one coming in June, you wouldn’t have data for April and May, making it impossible to calculate.

To reinforce our understanding, let’s manually calculate the TTM P/E Ratio. First, we need to calculate the TTM EPS. If we must calculate it ourselves, we would find the EPS from the financial reports of the past four quarters and then add them together. However, BestStock already provides the TTM EPS.

So TTM P/E Ratio = 191.49 (current stock price) / 3.56 (TTM EPS) = $53.78, which matches the TTM P/E Ratio from the initial screenshot.

End

And that’s a wrap for our thorough explanation of the P/E Ratio! If you still have any questions, feel free to leave a comment below. See you in our next article!