Stock Valuation Must-Learn: What is a Reasonable Price-to-Earnings Ratio? A Complete Guide from Beginner to Expert

Why Are Investors Always Watching the Price-to-Earnings Ratio?

When investing in stocks, the Price-to-Earnings ratio (PE or P/E ratio) is almost always mentioned by analysts. It provides an intuitive way to tell whether a stock is cheap or expensive right now. Simply put, the P/E ratio is a yardstick for measuring a company’s value in monetary terms, helping you determine whether your investment is worthwhile or just a sucker’s bet.

What Exactly Does the P/E Ratio Measure?

The P/E ratio (Price-to-Earnings Ratio, abbreviated PE) indicates how many years it would take for the company’s earnings to recover your investment. In other words, if a stock’s P/E ratio is 13, it means you need 13 years of the company’s net profit to recoup your initial investment.

Taking TSMC as an example, its P/E ratio has hovered around 13, meaning the company’s net profit over 13 years could be used to match its current market value. Companies with low P/E ratios seem cheap, while high P/E ratios suggest the market has higher expectations (usually due to good growth prospects).

How to Calculate the P/E Ratio? Core Formula in One Minute

There are basically two ways to calculate the P/E ratio:

Method 1 (Most Common): Stock Price ÷ Earnings Per Share (EPS)

For example, TSMC’s stock price is NT$520, and its EPS last year was NT$39.2: P/E = 520 ÷ 39.2 = 13.3 times

Method 2: Company Market Cap ÷ Net Profit

Both methods yield the same result, but the first is more convenient.

There Are Three Types of P/E Ratios—Are You Using the Right One?

Depending on the earnings data used, the P/E ratio is divided into three categories, each with its pros and cons:

Static P/E Ratio: Uses past data

Calculation: Stock Price ÷ Annual EPS

The static P/E uses the confirmed earnings from the previous year. For example, TSMC’s 2022 EPS is calculated by summing the four quarters (Q1: 7.82 + Q2: 9.14 + Q3: 10.83 + Q4: 11.41 = 39.2), then dividing by the current stock price to get the static PE.

Since the annual EPS is fixed, fluctuations in PE are entirely due to stock price changes, hence called “static.” This indicator reflects past facts but can be lagging.

Rolling P/E (TTM): Uses the most recent 12 months

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

This method is more timely than static PE. Suppose TSMC’s latest announced Q1 2023 EPS is NT$5; then the latest 4 quarters sum to: 22Q2 (9.14) + 22Q3 (10.83) + 22Q4 (11.41) + 23Q1 (5) = 36.38

PE (TTM) = 520 ÷ 36.38 ≈ 14.3 times

When new quarterly reports are released, the rolling PE updates automatically, avoiding the lag of static PE, but it still cannot predict future trends.

Dynamic P/E: Uses forecasts

Calculation: Stock Price ÷ Estimated Annual EPS

Dynamic PE is calculated based on forecasts of future earnings by institutions, theoretically reflecting the company’s outlook. However, different analysts’ estimates vary widely, and companies often overstate or underestimate their forecasts, limiting this indicator’s practical usefulness.

What Is a Reasonable P/E Ratio? Two Ways to Judge

When you see a P/E number, how do you determine if it’s high or low?

Benchmarking: Compare with industry peers

P/E ratios vary greatly across industries. In 2023, Taiwan’s stock market data shows the automotive industry with a P/E of 98.3, while the shipping industry is only 1.8—obviously not comparable directly.

The correct approach is to compare only within the same industry, ideally with similar business types. For example, compare TSMC with UMC (PE around 15), Powertech (台亞), and other peers. If TSMC’s PE is 23.85 and UMC’s is 15, it indicates the market assigns a higher valuation premium to TSMC.

Historical Method: Look at the company’s own PE history

Compare the current PE with the company’s past PE levels to gauge its position. TSMC’s current PE of 23.85 is in the upper-middle range over the past five years, neither at bubble highs nor at recession lows, reflecting a healthy recovery after economic improvement.

P/E Flow Chart: A Single Chart to See Overvaluation and Undervaluation

Want to quickly judge if a stock is expensive or cheap? The P/E flow chart is an excellent tool.

Its principle is simple: Stock Price = EPS × P/E ratio

The chart usually shows 5 to 6 lines, with the top line based on the highest historical P/E and the bottom line on the lowest. The middle lines represent different reasonable valuation ranges.

For example, with TSMC, if the latest stock price falls between the prices corresponding to 13x and 14.8x P/E, and the chart indicates a lower zone, it suggests undervaluation. This is often a good buying opportunity, but remember—undervaluation doesn’t guarantee profit; consider fundamentals and market conditions as well.

The Three Major Pitfalls of P/E Ratio Investing

While useful, the P/E ratio has clear limitations:

Cannot see a company’s debt risk

The P/E ratio only reflects shareholder equity value and completely ignores corporate debt. Two companies with the same EPS and P/E might have vastly different risks—one financed with equity, the other heavily leveraged. When interest rates rise or the economy downturns, high-debt companies face greater pressure, but this isn’t visible from PE alone.

Difficult to judge whether a P/E is truly high

A high P/E doesn’t necessarily mean expensive. Sometimes, it’s because the company is temporarily in trouble but its fundamentals remain intact, and the market still holds a positive outlook; other times, it’s due to high growth expectations. Similarly, a low P/E might be a sign of a rebound from oversold conditions. Each case is different, and relying solely on historical experience can be misleading.

New and biotech stocks cannot be evaluated with P/E

Many emerging companies are not profitable yet, so P/E cannot be calculated. In such cases, alternative valuation metrics like Price-to-Book (PB) or Price-to-Sales (PS) are used.

P/E, PB, PS: Choosing the Right Valuation Tool Is Key

Once you master how to judge a reasonable P/E, you can make smarter stock picks. Combining PE, PB, PS, along with fundamental and technical analysis, makes your investment decisions more comprehensive and rational. Remember, low valuation is just one factor; you also need to consider company prospects, industry trends, and your own risk tolerance to find truly worthwhile companies.