Knowing and Setting the Upper Limits of Share Price

The P/E also can be used to establish a cap on intrinsic value.

While asset values set the lowest level for estimating intrinsic value, the P/E can serve as an upper limit.

The P/E ratio establishes the maximum amount an investor should pay for earnings.

• If the investor decides that the appropriate P/E ratio for a stock is 10, the share price paid should be no more than 10 times most recent yearly earnings.

It is not wrong to pay more, Graham and Dodd noted; it is that doing so enters the realm of speculation.  

• Since young, rapidly expanding companies generally trade at a P/E ratio of 20 to 25 or above, Graham usually avoided them, which was one reason he never invested in some new start up stocks, though he used and was impressed by their products early in his career.