How investors use the P/E formula to evaluate stocks

Key Points

• The P/E system shows what price investors are willing to pay for each dollar of the company's profit — this is the main tool for identifying undervalued and overvalued assets.
• There are several calculation options: based on current data (trailing), forecast indicators (forward), absolute and relative analysis.
• When using the P/E formula, it is essential to always consider industry standards and the company's growth rates.
• Cryptocurrencies do not fit traditional P/E valuation as they do not generate profit in the classical sense; however, some DeFi platforms are beginning to apply similar methodologies.

Introduction: Why is the P/E Formula Necessary

When you think about investing in stocks, the main question arises: am I overpaying? The price-to-earnings ratio is a tool that helps answer it. It is one of the most commonly used among traders and investors when analyzing the attractiveness of securities. Let's figure out how to use it in practice and what to pay attention to.

Understanding the P/E Ratio: Basic Principles

The P/E ratio links two key indicators: the market price of a single share and the company's earnings attributable to that share. This allows for the comparison of different companies and determines whether their current market valuation is justified.

The essence is simple: the ratio shows how much money investors are willing to invest to receive one dollar of annual profit from the company. A high figure indicates that the market has high hopes for the company, while a low figure can indicate both a good deal and problems in the business.

P/E Calculation: Practical Formula

The classic formula:

P/E = Stock Price ÷ Earnings Per Share (EPS)

Where EPS ( earnings per share ) is calculated as:

EPS = (Net income of the company) ÷ (Number of common shares outstanding)

Practical example: if a stock is priced at 100 dollars and the earnings per share is 5 dollars per year, then P/E = 100 ÷ 5 = 20. This means that investors are paying 20 dollars for every dollar of annual profit.

Calculation Options: Which One to Choose

Analysts use different approaches to calculating P/E depending on the task at hand:

Current (Trailing) P/E — is based on the actual earnings of the company over the last 12 months. This is the most honest metric as it uses actual data already known to the market.

Forecast (Forward) P/E — is based on analysts' expectations regarding earnings in the next 12 months. A more optimistic figure, useful for assessing growth, but depends on the accuracy of forecasts.

Absolute P/E is simply the ratio of the current stock price to the most recent known EPS. This is a basic calculation without additional analysis.

Relative P/E - compares the ratio of a specific company with the industry average or historical values of the same company. It helps to determine whether the stock is overvalued in comparison to its peers.

What High and Low P/E Means: Context is Everything

The interpretation of the ratio should never be in a vacuum. A high P/E often signals that investors believe in future profit growth and are willing to pay a premium. Companies in a rapid scaling phase usually have high ratios, and that is normal.

A low P/E can mean two completely different things: either the stock is truly undervalued, or the company is facing problems and the market reflects this in the price.

The main rule: always compare companies within the same industry. Technology companies traditionally have higher P/E ratios (20-30 and above) due to growth potential, while utilities and banks operate with ratios of 10-15. This does not mean that some are cheaper and others are more expensive — it reflects the difference in business models.

Practical Application: How Investors Use P/E

Search for Undervalued Stocks (screening) — P/E allows for a quick filter of companies whose stocks are trading below the industry average. This is the first step in identifying potential opportunities.

Tracking Historical Trends — if a company used to trade at a P/E of 25 and now trades at 15, this may indicate either past overvaluation or current issues. Historical analysis helps to understand the evolution of the market's perception of the company.

Comparative analysis — the company's P/E placement against industry standards and the broader market shows whether the current valuation is justified or not.

Limitations: when P/E can let you down

P/E is a powerful tool, but not a panacea:

Does not work with unprofitable companies — if a company is losing money, EPS is negative, and the ratio loses its meaning.

Does not distinguish between sources of growth — a high P/E may be justified for an e-commerce giant, but the same ratio for a traditional manufacturer could be a red flag.

Vulnerable to reporting manipulations — some companies may change accounting principles to present profits more favorably.

Ignores credit burden — two P/E ratios of 20 can hide completely different situations: one company has low debt, while the other has huge loans.

Therefore, the P/E ratio should be analyzed together with other indicators: the debt ratio, free cash flow, profit margin, and revenue growth rates.

Industry context: a comparison through the lens of the sector

For a correct analysis, always look at companies in the context of their industry:

Technology: high P/E ( often 25-50), as investors expect exponential growth. R&D costs are high, but they pay off over time.

Utilities: low P/E (10-15), stable, predictable income, minimal growth, but reliable dividends.

Healthcare: variable indicators (15-25), depends on whether the company works with expensive drugs (high P/E) or produces generics (low).

Comparing a tech startup to a utility company based on one P/E will lead you to incorrect conclusions.

P/E in the context of cryptocurrencies: is it applicable here

Does the classic P/E formula work for Bitcoin and other cryptocurrencies? Short answer: no, in the traditional sense.

Reason: cryptocurrencies are not profit-making companies. Bitcoin is a network, Ethereum is a platform. They do not publish quarterly earnings reports, do not pay taxes, and do not have EPS in the traditional sense.

However, there is an interesting development. In decentralized finance (DeFi), some platforms do indeed generate income through fees. Analysts are beginning to apply similar methodologies, assessing the value of such protocols relative to their annual income from fees. This is an experimental approach, but it demonstrates attempts to transfer traditional financial instruments into the crypto ecosystem.

For cryptocurrencies, completely different metrics are used: the ratio of market capitalization to daily trading volume, the relationship to blockchain activity, comparison with historical highs.

Results: P/E as a Starting Point for Analysis

The price/earnings ratio (P/E) is one of the most accessible and useful indicators for assessing the fairness of a stock's price. It quickly shows how much investors are paying for a company's earnings and helps compare different investment options within the same sector.

But remember: P/E is the beginning of the analysis, not the end. Always complement it with an analysis of debt, cash flows, profit margins, and growth prospects. Combining several metrics provides a much more complete picture than relying on a single indicator.

Use P/E as the first filter to identify stocks of interest, and then deepen your analysis by studying fundamental indicators and industry trends.