Complete Guide to Price-to-Earnings Ratio: Learn PE Valuation from Scratch

Essential Knowledge of Price-to-Earnings Ratio (P/E Ratio) for Stock Investment

When investing in stocks, the P/E ratio is the most fundamental reference indicator, frequently cited by analysts and professional investors alike. Understanding what the P/E ratio is, how to calculate it, and how to apply it is the first step into stock investing. This article will cover everything from basic concepts to practical applications, helping you fully grasp this key metric.

What is the P/E Ratio?

The P/E ratio, also known as the Price-to-Earnings ratio, abbreviated as PE or PER (Price-to-Earning Ratio), indicates how many years it would take for a stock’s earnings to recover its current price. It is an important tool for assessing a company’s stock valuation.

For example, if TSMC’s current P/E ratio is around 13, it means the company needs 13 years of earnings to reach its current market value. In other words, buying the stock at the current price would require about 13 years to break even through profits.

The basic logic of the P/E ratio is simple: a lower P/E generally indicates a cheaper stock, with the market assigning a more conservative valuation; a higher P/E suggests optimistic market expectations for the company’s future growth, reflecting market confidence in its prospects.

How to Calculate the P/E Ratio? The Core Formula Revealed

There are two methods to calculate the P/E ratio:

Method 1: Stock Price ÷ Earnings Per Share (EPS)
Method 2: Company Market Capitalization ÷ Net Income attributable to common shareholders

In practice, the first method is most commonly used. For example, if TSMC’s current stock price is NT$520 and its 2022 EPS is NT$39.2, then the P/E ratio = 520 ÷ 39.2 ≈ 13.3.

This number indicates that, at the current stock price, it would take approximately 13.3 years of earnings to recover the investment.

Three Classifications of the P/E Ratio

Depending on the EPS data used, the P/E ratio can be divided into historical P/E and estimated P/E. Historical P/E can further be subdivided into static P/E and rolling P/E.

Static P/E: A snapshot of past performance

Calculation formula: PE = Stock Price ÷ Annual EPS

Static P/E uses EPS data from the past year. For example, TSMC’s 2022 EPS is calculated by summing four quarters: Q1 (7.82) + Q2 (9.14) + Q3 (10.83) + Q4 (11.41) = 39.2.

Since the annual EPS remains unchanged before the new year’s report, fluctuations in PE are entirely due to stock price changes. This is what “static” means. The advantage of this method is data stability; the downside is the time lag.

Rolling P/E: Dynamic performance over the most recent 12 months

Rolling P/E, also known as TTM (Trailing Twelve Months), calculates the P/E ratio based on the latest 12 months. Since listed companies release quarterly reports, in practice, it uses the latest four quarters’ EPS.

Calculation formula: PE (TTM) = Stock Price ÷ Sum of EPS of the latest 4 quarters

For example, if TSMC reports a Q1 2023 EPS of NT$5, and the latest four quarters’ EPS sum to: Q2 (9.14) + Q3 (10.83) + Q4 (11.41) + Q1 (5) = NT$36.38, then PE (TTM) = 520 ÷ 36.38 ≈ 14.3.

Compared to the static PE of 13.3, the rolling PE has increased to 14.3. This method overcomes the time lag issue and better reflects the company’s recent performance.

Estimated P/E: Future expected valuation

Estimated P/E uses projected annual EPS to calculate: PE = Stock Price ÷ Estimated Annual EPS

If an institution forecasts TSMC’s 2023 EPS at NT$35, then dynamic PE = 520 ÷ 35 ≈ 14.9.

Note that different institutions’ EPS forecasts can vary significantly, and companies often have optimistic or conservative biases. Therefore, while this indicator reflects future expectations, its accuracy carries considerable uncertainty.

What P/E Ratio is Considered Reasonable? Two Main Methods of Judgment

When seeing a company’s P/E ratio, how do you determine if it’s high or low? The industry generally compares using two methods.

Method 1: Horizontal comparison within the same industry

Different industries have vastly different P/E ratios. For example, the automotive industry might have a P/E as high as 98.3, while the shipping industry might only be 1.8. Clearly, cross-industry comparison is invalid.

Only companies within the same industry and similar business models should be compared. For example, TSMC should be compared with UMC, Powertech, and other peers. If TSMC’s P/E is 23.85 and UMC’s is 15, then TSMC’s P/E is relatively higher.

Method 2: Vertical comparison within the same company

Compare the current P/E with the company’s historical levels to judge whether the current valuation is high or low.

For example, TSMC’s current P/E of 23.85 falls within its five-year historical range, in the “upper-middle zone”—not at the bubble high point, but clearly above recession lows, indicating a steady upward trend as market outlook improves.

P/E River Chart: Visual Judgment of Stock Price Highs and Lows

If you want a more intuitive way to judge whether a stock is overvalued or undervalued, the P/E river chart is a practical tool.

The river chart typically displays 5 to 6 parallel lines over the stock price trend, with each line calculated as: Stock Price = EPS × P/E ratio.

The top line is based on the historical highest P/E, and the bottom line on the historical lowest P/E. The middle lines represent the historical average or median levels.

For example, if TSMC’s latest stock price is between the two lines (corresponding to P/E of 13 to 14.8), it indicates the current price is relatively undervalued. This is often a good entry point, but note that undervaluation does not guarantee the stock will rise, as many factors influence stock prices beyond valuation.

The Truth About P/E Ratio and Stock Price Movements

Low P/E does not necessarily mean the stock will rise; high P/E does not necessarily mean it will fall. There is no direct causal relationship between P/E and stock price trends.

Market’s willingness to assign high valuation to a company stems from optimism about its future growth prospects. That’s why we often see tech stocks with high P/E ratios reaching new highs—high valuation reflects confidence in future growth.

Conversely, stocks with low P/E ratios may continue to decline if the market is pessimistic about their prospects. P/E is a valuation tool, not a stock price prediction tool.

Three Major Limitations and Cautions in Using the P/E Ratio

1. Ignores corporate debt risk

The P/E ratio considers only equity value and does not account for a company’s debt. The same P/E can be associated with a low-debt or high-debt company, but the actual risk differs greatly.

For example, Company A’s profits come from its own assets, while Company B’s profits are from borrowed funds. During economic downturns or rising interest rates, the risks faced by B are much higher. Simply saying B is cheaper is inaccurate; A is safer and should command a premium.

2. Misleading interpretation of high or low P/E

A high P/E might be due to temporary headwinds causing profit decline, but the company’s fundamentals remain intact, and the market still holds confidence; it could also be because the market anticipates future growth, making the current high valuation reasonable; or it might be an overhyped stock needing correction.

Since the meaning of a P/E ratio varies greatly depending on context, it’s difficult to judge its reasonableness based solely on historical experience.

3. Cannot evaluate unprofitable companies

Many startups or biotech firms have yet to generate profits, making P/E evaluation impossible. In such cases, other indicators like Price-to-Book (PB) and Price-to-Sales (PS) ratios should be used.

Comparison of the Three Major Valuation Indicators: PE, PB, PS

Practical Application: How to Use P/E Ratio for Stock Selection

After understanding how to calculate and interpret the P/E ratio, the key is how to apply it in actual investment decisions. Selecting stocks with relatively low P/E ratios, combined with industry comparison and company historical trends, can help investors find assets with a margin of safety.

Using the P/E river chart to observe the stock’s position, along with considering company fundamentals, industry outlook, and growth potential, enables more rational investment choices. Remember, undervaluation is just the starting point, not the end goal.