Unveiling the Price-to-Earnings Ratio Formula: A Complete Guide from Valuation Confusion to Precise Stock Selection

What exactly is the Price-to-Earnings Ratio (P/E)?

In the world of stock investing, many people get confused by the concept of the “P/E ratio.” Actually, it’s not that mysterious; it’s simply an indicator used to measure whether a company’s stock is expensive or cheap.

The P/E ratio is also called the Price-to-Earnings ratio, abbreviated as PE or PER (Price-to-Earning Ratio). The most straightforward understanding is: based on the current profit rate, how many years will it take to recover your investment? For example, if a company’s P/E ratio is 13, it means that at the current profit level, it will take 13 years to earn back your investment.

To give a concrete example, TSMC’s current P/E ratio is around 13. If you buy TSMC stock today, theoretically, it will take 13 years to recover your principal through the company’s profits. Conversely, the P/E ratio is like the market’s “valuation multiple” for this company— the lower the P/E, the cheaper the stock; the higher the P/E, the more the market is willing to pay, usually because it expects strong growth potential.

How to use the P/E ratio formula? Step-by-step guide

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

The first and most common method: Stock Price ÷ Earnings Per Share (EPS) = P/E ratio

The second method uses company-level data: Market Capitalization ÷ Net Income attributable to common shareholders = P/E ratio

Most investors use the first method because it’s more intuitive.

Let’s do a practical example. Take TSMC (2330.TW). Suppose the current stock price is 520 TWD, and the EPS for 2022 is 39.2 TWD. Then, based on the P/E formula:

520 ÷ 39.2 = 13.3

This was TSMC’s P/E ratio at that time. Pretty simple, right?

How many types of P/E ratios are there? Don’t get confused by “static,” “rolling,” and “dynamic”

Depending on the source of earnings data used, P/E ratios can be divided into three main types. Understanding these differences can greatly improve your stock selection accuracy.

Static P/E Ratio: Valuation based on last year’s results

Calculation formula: Stock Price ÷ Annual EPS

The static P/E uses the published annual EPS data. For example, TSMC’s 2022 EPS = Q1EPS + Q2EPS + Q3EPS + Q4EPS = 7.82 + 9.14 + 10.83 + 11.41 = 39.2 TWD.

Why is it called “static”? Because the annual EPS is fixed until a new annual report is released. The P/E ratio only changes with stock price movements; EPS remains constant.

Advantages: Data is already published, most reliable
Disadvantages: Can lag behind, especially at the start of the year when using last year’s data, which may deviate from current reality

Rolling P/E (TTM): Based on the most recent 12 months’ results

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

The rolling P/E is also called TTM (Trailing Twelve Months), meaning it covers the most recent 12 months. Since listed companies release quarterly reports, in practice, it sums the EPS of the last four quarters.

Using TSMC as an example: suppose the EPS for Q1 2023 is 5 TWD, then the total EPS for the last four quarters is:

22Q2EPS + 22Q3EPS + 22Q4EPS + 23Q1EPS = 9.14 + 10.83 + 11.41 + 5 = 36.38 TWD

Based on the P/E formula: 520 ÷ 36.38 ≈ 14.3

Compare this with the static PE of 13.3; the rolling PE has already increased to 14.3.

Advantages: Overcomes the lag of static indicators, closer to current conditions
Disadvantages: Changes with each new quarterly report, short-term fluctuations can be large

Dynamic P/E: Based on future earnings forecasts

Calculation formula: Stock Price ÷ Estimated annual EPS

The dynamic P/E is based on forecasts from major institutions about the company’s future earnings. For example, if an institution estimates TSMC’s 2023 EPS at 35 TWD, then the dynamic PE is 520 ÷ 35 ≈ 14.9.

Advantages: Reflects expectations for the future, allows early positioning for growth opportunities
Disadvantages: Forecasts are often inaccurate; different institutions may have different EPS estimates, leading to decision confusion

How high is a “reasonable” P/E? How to avoid getting “cut” by the market

Knowing how to calculate the P/E ratio isn’t enough; it’s more important to judge whether a company’s P/E is high or low. Investors often use two methods to evaluate this.

Method 1: Horizontal comparison within the same industry

Different industries have vastly different P/E ratios. For example, according to industry data published by Taiwan Stock Exchange in February 2023: the PE of the automotive industry is as high as 98.3, while the shipping industry PE is only 1.8. Comparing companies across these industries is meaningless.

Therefore, the correct approach is: Compare within the same industry, preferably among companies with similar business types.

Taking TSMC as an example, compare it with peers like UMC (2303.TW), Taya (2340.TW), etc. As of December 2025, TSMC’s PE is 23.85, UMC’s PE is 15. Compared to that, TSMC’s P/E is noticeably higher, indicating the market assigns a higher valuation premium to TSMC.

Method 2: Vertical analysis of the company’s historical performance

Compare the current P/E with its historical P/E to determine if the stock price is high or low.

For TSMC, the current PE is 23.85. Looking at the past five years, it is in the “upper-middle range”—not at bubble-high levels nor at the low point of recession, showing a healthy rebound after economic and expectation improvements.

P/E River Map: Visual tool to instantly see if a stock is expensive or cheap

If you find numbers too abstract, there’s a more intuitive tool: the P/E River Map.

The P/E River Map uses 5 to 6 curves to show the theoretical stock prices at different P/E multiples. The calculation is simple: Stock Price = EPS × P/E multiple.

The topmost line is based on the historical highest P/E, representing the theoretically overvalued price; the bottom line is based on the historical lowest P/E, representing the undervalued price. The middle lines represent different P/E multiples.

Looking at TSMC’s P/E river map, you’ll see the latest stock price is between two middle lines (around 13 to 14.8 PE), indicating the price is relatively undervalued. This is often considered a good buying point, but remember: The stock price ultimately depends on many factors. A low P/E is just a reference signal and doesn’t guarantee immediate price increase after purchase.

Will stocks with high P/E fall in the future? This is a misconception

Many novice investors have a misconception: There is no inevitable causal relationship between P/E and stock price movement.

Low P/E stocks don’t necessarily rise, and high P/E stocks don’t necessarily fall. People are willing to give certain stocks high valuations because they are optimistic about the company’s future growth prospects. So you’ll see many tech stocks with high P/E but continuously reaching new highs. This isn’t market madness; it’s the market valuing the company’s growth potential and innovation.

Conversely, some traditional industry companies with low P/E may continue to decline due to industry recession.

The three fatal weaknesses of P/E: Don’t blindly trust it

Although the P/E ratio is the most commonly used valuation indicator, it is far from perfect. Investors must understand its limitations.

Weakness 1: Ignores a company’s debt burden

The P/E ratio only considers equity value, ignoring the company’s debt. The true value of a company should be the sum of equity and debt, but the P/E calculation completely ignores leverage.

For example: Company A and Company B have the same P/E ratio, but Company A is profitable solely with its own funds, while Company B has borrowed money to invest and profit. When market interest rates rise or the economy downturns, Company B faces much higher risks. Even with the same EPS, the market will assign a higher stock price to Company A because it’s safer. So, a low P/E of B doesn’t necessarily mean it’s cheaper.

Weakness 2: Difficult to define “high” and “low” precisely

A high P/E can have many reasons and shouldn’t be generalized.

Sometimes a high P/E is because the company is currently facing headwinds, with profits temporarily declining, but the company’s fundamentals are sound, and the market still holds it; other times, it’s because the market anticipates future growth, thinking this year is expensive but next year will be reasonable, so investors buy early; of course, it could also be overhyped and due for correction.

All these situations depend on the specific circumstances of the company and are hard to judge solely based on historical experience.

Weakness 3: Not applicable to startups and loss-making companies

Many startups and biotech firms have no profits at all, so P/E can’t be calculated. In such cases, investors need to use other valuation metrics, such as Price-to-Book (PB) or Price-to-Sales (PS).

PE, PB, PS: The differences and applications of the three main valuation indicators

Since the P/E ratio has limitations, other tools are needed to supplement. Here’s a comparison of the three main valuation metrics:

PE (Price-to-Earnings Ratio / Market P/E)

• Calculation: Stock Price ÷ EPS or Market Cap ÷ Net Profit
• Judgment: Higher PE means more expensive; lower PE means cheaper
• Suitable for: Profitable, mature companies with stable earnings

PB (Price-to-Book Ratio / Market P/B)

• Calculation: Stock Price ÷ Book Value per Share or Market Cap ÷ Shareholders’ Equity
• Judgment: PB < 1 indicates undervaluation; PB > 1 indicates overvaluation
• Suitable for: Cyclical industries

PS (Price-to-Sales Ratio / Market P/S)

• Calculation: Stock Price ÷ Revenue per Share or Market Cap ÷ Revenue
• Judgment: Higher PS indicates more expensive stock
• Suitable for: Unprofitable startups and emerging industries

Mastering these three indicators and combining them flexibly with the P/E formula gives you a basic valuation toolkit. Different company types require different indicator combinations to make more rational investment decisions. Remember: valuation is just the first step; company fundamentals, industry outlook, management team, and other factors are equally critical.