The PER: How to interpret this key metric in stock analysis

A Fundamental Tool but Not Sufficient

When we delve into fundamental analysis of listed companies, there is an indicator that constantly appears in conversations among investors and analysts: the P/E ratio. Despite its omnipresence, many make the mistake of considering it as the only factor for making investment decisions. The reality is that, although the P/E is a valuable metric, its correct interpretation requires combining it with other elements of financial analysis.

Definition and Calculation of the P/E Ratio

The P/E ratio stands for Price/Earnings Ratio, which in Spanish we know as Price/Earnings Ratio. It is a coefficient that establishes the relationship between a company’s market value and its periodic earnings. In simple terms, it shows how many times the company’s net profit is reflected in its market capitalization.

There are two equivalent methods to calculate it:

First formula (using global magnitudes):

• Market Capitalization ÷ Net Profit

Second formula (using per-share data):

• Share Price ÷ Earnings Per Share (EPS)

Both approaches yield the same result. Let’s look at a practical example: if a company has a market capitalization of 2,600 million dollars and profits of 658 million, its P/E would be 3.95. This means that the profit of one year would be enough to recover the investment in approximately four years.

The Importance of Correct Reading by Sector

One of the most common pitfalls when using the P/E ratio is comparing companies from different sectors without adjusting our expectations. Banks and industrial companies typically maintain low ratios (close to 2-3), while technology and biotech firms tend to record much higher values (above 50-100).

For example, a metallurgy company might have a P/E of 2.58, which in another context would seem like a bargain. However, a software firm specializing in remote communications could reach a P/E of 200 or higher, and still represent a good valuation within its sector.

The key is always to compare “apples with apples and oranges with oranges.” Two companies in the same sector, operating in similar geographies, will be under comparable market conditions, making cross-analysis of their ratios relevant.

Interpretation of P/E Ranges

Between 0 and 10: A low metric may indicate a good buying opportunity, but it is also a sign of market distrust. Sometimes, these companies have low projected future profits or face structural difficulties.

Between 10 and 17: This range is considered optimal by many analysts, reflecting expected moderate growth without reaching levels of speculative euphoria.

Between 17 and 25: Here, interpretative ambiguity begins. It may indicate that the company has recently experienced accelerated growth, or that the market is assigning very positive expectations for the future.

Above 25: This zone is especially complex. Sometimes it reflects projections of exceptional growth and confidence in management; other times, it indicates a speculative bubble in formation.

Variants of the P/E: the Shiller approach and the normalized

There is an alternative model proposed by economist Robert Shiller that attempts to address a fundamental limitation of the conventional P/E: its dependence on profits from a single year. The Shiller P/E divides the market capitalization by the average of inflation-adjusted earnings over the last ten years. The theory suggests that this broader period allows for more reliable projections of profits over the next twenty years.

Another variant, the normalized P/E, goes further. Instead of only taking net profits, it subtracts liquid assets and adds financial debt in the numerator, while using free cash flow in the denominator. This approach reveals the company’s true financial health, especially useful in mergers and acquisitions where nominal data can be misleading.

Limitations We Should Not Ignore

Although the P/E is widely used, it has significant shortcomings:

• Short-term focus: It only considers the previous year’s profits to project the future.
• Inapplicable to losses: If a company does not generate profits, the P/E has no meaning.
• Static reflection: It does not capture dynamic changes in management or the competitive environment.
• Problems with cyclical companies: At the peak of the cycle, they will have a low P/E; at the trough, a high P/E, distorting comparative readings.

How to Combine the P/E with Other Indicators

The history of markets is full of companies with attractive P/E ratios that later failed. A robust analysis requires complementing the P/E with metrics such as the EPS (evolution of earnings per share), the Price/Book ratio, ROE (return on equity), and ROA (return on assets).

It is advisable to spend time examining the composition of reported earnings. Do they come from operational business or from one-time asset sales? Have there been significant changes in costs or margins? These questions will help avoid unpleasant surprises.

The P/E in Value Investing Strategies

Investors practicing so-called Value Investing extensively use the P/E as an initial filter to identify undervalued companies. Value-focused management funds typically maintain portfolios with ratios significantly below the average of their categories, reflecting their deliberate search for “good companies at a good price.”

However, even within this philosophy, the P/E never acts alone. It is combined with analysis of historical trends, sector comparisons, and medium-term growth projections.

Conclusion: a Contextualized Tool

The P/E is a practical and easily accessible metric that provides a first approximation of a company’s value. Its greatest strength lies in enabling quick comparisons between similar companies. However, relying solely on the P/E to make investment decisions is a rookie mistake.

A solid investment strategy requires examining the P/E within its context: sector activity, underlying financial health, competitive dynamics, and growth prospects. Spend time understanding the business intricacies, consult multiple indicators, and only then can you build a truly profitable and sustainable portfolio.