Must-read for stock investing: Meaning, calculation method, and practical application guide of P/E ratio

When investing in stocks, there is one indicator that investors most often mention—Price-to-Earnings Ratio (PE or PER). Whether it’s financial advisors or seasoned investors, they use it to judge whether a stock is a good buy or should be held off. But for beginner investors, what exactly does the PE ratio mean, and why is it so important? This article will explain this seemingly complex indicator in the simplest way possible.

What Does the PE Ratio Mean? Understand It in One Sentence

Price-to-Earnings Ratio (PE or PER, also called Price-to-Earnings Ratio), known as 市盈率 in Chinese, simply means: how many years it would take to recover your investment at the current stock price based on all the profits.

A more intuitive way to understand—if you buy a stock and the company’s annual profit is distributed to you, how many years would it take to earn back your original investment? That “number of years” is the PE ratio.

For example, TSMC currently has a PE ratio of about 13, meaning that based on its current profit level, it would take 13 years to earn back its current market value. Conversely, buying TSMC stock now, at its past profit rate, would require 13 years to break even.

Therefore, the PE ratio essentially answers a key investor question: Is this stock’s current price expensive or cheap?

How to Calculate the PE Ratio? Two Methods for You to Choose

Method 1: Stock Price divided by Earnings Per Share (most common)

Calculation formula: PE = Stock Price ÷ Earnings Per Share (EPS)

Taking TSMC as an example, suppose the stock price is 520 NT dollars, and the EPS for 2022 is 39.2 NT dollars, then: PE = 520 ÷ 39.2 = 13.3 times

Method 2: Company Market Cap divided by Net Profit

Calculation formula: PE = Total Market Cap ÷ Net Profit attributable to common shareholders

Both methods are logically consistent, just measured from different perspectives. The first method is more straightforward and widely used in practice.

Three Types of PE Ratios: Static, Rolling, Dynamic

Depending on the time period of the profit data used, PE ratios can be divided into three main types, each with its own uses and limitations.

Static PE (the most straightforward historical PE)

Calculation: Stock Price ÷ Annual EPS

Static PE uses EPS data from a full past year. For example, TSMC’s 2022 EPS sums up Q1(7.82) + Q2(9.14) + Q3(10.83) + Q4(11.41) = 39.2 NT dollars.

This data is relatively stable—won’t change before the new annual report is released. The PE fluctuation is entirely due to stock price changes. Hence, it’s called “static” PE.

The downside is lagging—since it uses last year’s data, it may not reflect the company’s latest profit situation.

Rolling PE (TTM, the most real-time reference)

Calculation: Stock Price ÷ Sum of EPS over the latest 4 quarters

Rolling PE, also called TTM (Trailing Twelve Months), uses the most recent 12 months of data. Since listed companies report quarterly, this is essentially the sum of the latest 4 quarters’ EPS.

Suppose TSMC’s latest quarter(2023Q1) EPS is 5 NT dollars, then the latest 4 quarters’ EPS sum is: 22Q2(9.14) + 22Q3(10.83) + 22Q4(11.41) + 23Q1(5) = 36.38 NT dollars

PE(TTM) = 520 ÷ 36.38 ≈ 14.3 times

Compared to static PE of 13.3, the rolling PE is now 14.3. This is the advantage of rolling PE—it reflects the company’s profit changes more promptly and with less lag.

Dynamic PE (forward-looking, estimated PE, most forward-looking but also most risky)

Calculation: Stock Price ÷ Estimated Annual EPS

Dynamic PE uses forecasts from brokers or research institutions. For example, if an analyst estimates TSMC’s 2023 EPS at 35 NT dollars, then: Dynamic PE = 520 ÷ 35 ≈ 14.9 times

It sounds forward-looking, but the problem is: forecasts are often inaccurate. Different institutions’ estimates vary greatly, and companies’ own forecasts may be overly optimistic or conservative. So, while it can reflect future expectations, its practical reliability is the weakest.

What PE Ratio Is Reasonable? Two Methods to Judge

After obtaining a stock’s PE ratio, how do you determine if it’s expensive or cheap? Investors often compare it using two benchmarks.

Horizontal industry comparison: peer comparison

PE ratios vary greatly across industries. According to Taiwan Stock Exchange industry data (February 2023):

• Automotive industry PE: as high as 98.3
• Shipping industry PE: only 1.8

Obviously, you can’t compare a car manufacturer with a shipping company directly. The proper approach is to compare companies within the same industry and similar business models.

For example, comparing TSMC with UMC and Powertech:

• TSMC PE: 13
• UMC PE: 8
• Powertech PE: 47

TSMC’s PE is between UMC and Powertech, not considered overvalued.

Vertical historical comparison: compare with its own past

Compare the current PE with the company’s historical PE to judge the current valuation level.

For TSMC, the current PE is 13, which is below 90% of its PE over the past 5 years. This indicates the current valuation is relatively cheap and might be a good entry point.

How to Use PE Ratio in Practical Investing?

PE River Chart: Visual judgment of high or low stock price

To quickly assess whether a stock is overvalued or undervalued, the PE River Chart is an excellent tool.

The river chart typically shows 5 to 6 curves on the stock price chart. Each line is calculated as: Stock Price = EPS × PE

• The top line uses the historical highest PE, representing the highest valuation level
• The bottom line uses the historical lowest PE, representing the lowest valuation level

Taking TSMC as an example, if the current stock price is in the lower region of the river chart (between PE 13 and PE 14.8), it indicates the stock is relatively undervalued. This is often a good buying signal, but remember—being undervalued doesn’t guarantee it will rise. It’s important to consider the company’s fundamentals and market environment as well.

The true relationship between PE and stock price movements

Many novice investors have a misconception: they think low PE stocks will definitely rise in the future, high PE stocks will definitely fall.

In reality, PE ratio and stock price movements are not causally linked.

A low PE stock might be undervalued because the market is pessimistic about its future prospects, but the stock price may not necessarily go up. Conversely, a high PE stock might be due to market optimism about its growth potential, and the stock price could keep rising. Many tech stocks have high PE ratios but continue to appreciate.

Therefore, PE is just a tool to assess the current valuation level, not a magic wand to predict future rises or falls.

Three Limitations of the PE Ratio: What You Must Know

Although PE is a commonly used valuation indicator, it’s not perfect. Investors must understand its limitations.

1. Ignores corporate debt risk

PE only considers equity profits and completely ignores the company’s debt situation. Two companies with the same PE might have very different risk profiles—one relies on low debt and assets for profit, the other is heavily leveraged. When economic conditions change or interest rates fluctuate, the leveraged company faces greater risks. So, even with the same PE, a company with less debt is safer. A low PE doesn’t necessarily mean it’s cheap.

2. Difficult to accurately interpret high or low PE

A high PE doesn’t always mean overvaluation. It could be that the company’s short-term performance is poor, but its long-term fundamentals are solid, and the market is willing to hold it; or that the market anticipates high growth in the coming years, and investors are positioning early; or that the stock is overextended and due for correction.

These situations vary by company and are hard to judge with a one-size-fits-all approach.

3. Cannot evaluate companies without profits

Many startups or biotech firms have yet to turn a profit, so PE is meaningless for them. In such cases, other valuation metrics are needed:

• Price-to-Book (PB): suitable for cyclical companies
• Price-to-Sales (PS): suitable for unprofitable or loss-making companies

PE, PB, PS: Comparing the Three Major Valuation Indicators

Summary: How to Correctly Use the PE Ratio in Investment

After understanding what the PE ratio means and how to calculate it, the key is how to apply it correctly. Remember these three points:

1. PE is a relative indicator, not an absolute truth—use it to judge whether a stock is relatively cheap or expensive, in conjunction with industry peers and historical levels.
2. Low PE doesn’t necessarily mean buy, high PE doesn’t necessarily mean sell—consider the company’s fundamentals, growth prospects, and industry cycle.
3. Use PE together with other indicators like PB and PS—PE only reflects profit valuation; combining multiple metrics provides a more comprehensive assessment.

Mastering the proper use of the PE ratio gives you a fundamental but crucial valuation tool in stock investing.