Stock valuation is actually very simple: you need to understand the logic behind the Price-to-Earnings ratio.

When it comes to stock investing, the Price-to-Earnings ratio (PE) is probably the most frequently mentioned indicator. Investors often hear comments like “This stock’s PE is only 13 times, it’s very cheap” or “That stock’s PE is 30 times, it’s too expensive.” But is the PE really that simple? Today, let’s break down this seemingly complex metric.

What exactly does the PE measure?

PE, also called the Price-Earnings Ratio (PER), is the English abbreviation for Price-to-Earning Ratio. In simple terms, it answers a question: at the current stock price, how long will it take to recover the initial investment using the company’s profits?

From another perspective, a lower PE indicates a relatively cheap stock; a higher PE suggests the market is willing to pay a premium to hold this stock — usually because investors are optimistic about the company’s future growth prospects.

For example, TSMC (2330.TW) has had a PE around 13. This means that, based on current profit levels, investors would need 13 years to recoup their initial investment.

How to calculate PE? Two methods to choose from

The most common calculation is: Stock Price ÷ Earnings Per Share (EPS).

Taking TSMC as an example, if the stock price is NT$520 and the EPS for 2022 is NT$39.2, then PE = 520 ÷ 39.2 ≈ 13.3 times.

Another method is to divide the company’s market capitalization by its net profit; the principle is the same, just from a different dimension.

How many types of PE are there? Which one should you choose?

This can be confusing. Depending on the time period of the EPS data used, PE can be divided into three types:

Static PE — calculated using the EPS of the past year. The advantage is that the data is confirmed; the downside is it doesn’t reflect the latest operational conditions.

Trailing Twelve Months (TTM) PE — calculated using the sum of the latest four quarters’ EPS. This indicator lies between “past” and “present,” providing a more timely reflection of the company’s situation. For example, if Q1 quarterly report is released, the TTM PE will incorporate the latest quarter data while excluding data from a year ago.

Forward PE — calculated using analyst estimates of EPS for the next year. It sounds future-oriented, but due to large differences in estimates among institutions, its accuracy often disappoints.

All three have their uses, but most investors rely on static and trailing PE for judgment.

What PE is considered “reasonable”?

This is the most difficult question to answer because there is no absolute standard. Two common approaches are:

Compare with peers — compare company A with other companies in the same industry, such as B and C. But beware: different industries have vastly different PE averages. For example, in 2023, Taiwanese listed companies show an average PE of 98 for the automotive industry, but only 1.8 for shipping. So, comparisons should be made among similar business types.

Look at historical data — compare the current PE with the stock’s performance over the past five or ten years. If the current PE is in the middle range historically, neither in a bubble at high levels nor at a low trough, it usually indicates a relatively balanced valuation.

How to use the PE river chart?

This is a practical visualization tool. Its principle is simple: Stock Price = EPS × PE.

The chart typically displays 5 to 6 lines, each representing the stock price at different PE multiples. The top line is calculated using the historical highest PE, and the bottom line using the lowest PE. The current stock price’s position on the chart visually indicates whether the stock is overvalued or undervalued.

If the stock price line is near the lower area, it often suggests a good buying opportunity. Conversely, if it’s near the top, it might be overvalued.

PE, PB, PS: what are these three indicators for?

PE is not the only valuation tool. When PE isn’t suitable, other indicators are considered:

PB (Price-to-Book Ratio) — suitable for analyzing cyclical companies. When PB is less than 1, the stock may be undervalued.

PS (Price-to-Sales Ratio) — used especially for evaluating startups or biotech firms that are not yet profitable. These companies have no earnings to calculate PE, but revenue data can still be referenced.

What should you watch out for when investing with PE?

While PE is useful, it has three clear limitations:

Ignoring debt risk — PE considers only equity value and ignores the company’s debt levels. Two companies with the same PE can have vastly different risks if one is heavily leveraged and the other is not.

Difficult to judge high or low precisely — a high PE might be due to a company experiencing a temporary downturn but with solid fundamentals, or it could be a bubble. Specific analysis is needed; there is no universal formula.

Cannot evaluate loss-making companies — startups and companies with losses cannot be assessed with PE; alternative tools are needed.

Final advice

PE is a helpful reference for investment decisions but not the whole story. A stock with a low PE doesn’t necessarily go up, and a high PE doesn’t necessarily fall. Stock prices are influenced by many factors — industry outlook, management quality, market sentiment, macroeconomic environment, and more.

Learning to interpret PE is the first step toward understanding stock valuation. True investing also requires more knowledge and market experience.