The Price-to-Earnings Ratio You Must Know for Stock Investment: A Complete Guide from Beginner to Expert

Many novice investors when looking at stocks often hear the term “Price-to-Earnings Ratio” (P/E ratio). Financial advisors almost always mention this ratio when analyzing individual stocks, indicating whether the current price is expensive or cheap. But if you haven’t fully understood what the P/E ratio is and how to use it, you’ll need to take some extra lessons. Because the P/E ratio is almost an essential knowledge for all stock investors.

What exactly does the P/E ratio measure?

The P/E ratio (also called the Price-to-Earnings ratio, abbreviated PE or PER in English) essentially measures one question: how many years will it take for your investment to break even if you buy the stock now?

From another perspective, it evaluates whether a company’s stock price is expensive or cheap at present. For example, if TSMC’s current P/E ratio is 13, it means: buying TSMC at the current price requires 13 years to recover your investment through the company’s earnings.

Based on this logic, we can derive a simple standard: Lower P/E = Cheaper stock; Higher P/E = More expensive stock. However, a high P/E can also reflect market optimism about the company’s future growth, especially for companies with good prospects and rapid growth, where the market is willing to assign a higher valuation.

How to calculate the P/E ratio? It’s actually very simple

There are two methods to calculate the P/E ratio, but the most common one is the first:

Formula: P/E ratio = Stock Price ÷ Earnings Per Share (EPS)(EPS)

Or using company-level data:

P/E ratio = Market Capitalization ÷ Annual Net Profit

Let’s try with actual numbers. Suppose TSMC’s current stock price is 520 NT dollars, and its EPS for 2022 is 39.2 NT dollars, then:

P/E ratio = 520 ÷ 39.2 ≈ 13.3 times

Very straightforward, right?

The P/E ratio has different “versions,” you need to know them all

This is a common confusion among investors. Depending on the data’s time frame used, the P/E ratio can be divided into three types:

Static P/E ratio: using last year’s financial data

The most straightforward P/E ratio, using the published annual EPS. The formula is:

Static P/E ratio = Stock Price ÷ Annual EPS

For example, TSMC’s 2022 full-year EPS = Q1(7.82) + Q2(9.14) + Q3(10.83) + Q4(11.41) = 39.2

Before the new year’s report is released, the annual EPS is fixed, so the P/E ratio’s fluctuation only comes from stock price changes. That’s why it’s called “static.”

Rolling P/E ratio (TTM)(: using the most recent 12 months’ data

This method is more recent; it sums the latest four quarters’ EPS to calculate, providing a quicker reflection of the company’s latest profitability.

Formula: Rolling P/E ratio = Stock Price ÷ )Sum of EPS of the latest 4 quarters(

For example, if Q1 2023 EPS is announced as 5, then the latest four quarters are:

22Q2)9.14( + 22Q3)10.83( + 22Q4)11.41( + 23Q1)5( = 36.38

Rolling P/E ratio = 520 ÷ 36.38 ≈ 14.3 times

Compare this with the static P/E of 13.3; the rolling P/E has already risen to 14.3. The rolling P/E overcomes the lag of the traditional P/E and can more timely reflect the company’s situation.

) Dynamic P/E ratio: using estimated EPS

The so-called “estimated” refers to forecasts by analysts or institutions about the company’s earnings in the coming year.

Formula: Dynamic P/E ratio = Stock Price ÷ Estimated annual EPS

Suppose an institution estimates TSMC’s 2023 EPS to be 35, then the dynamic P/E might be another figure.

But be aware that forecast data is often inaccurate; analysts tend to overestimate or underestimate, so this indicator’s reference value is relatively weaker.

What is a reasonable P/E ratio?

When you see a company’s P/E ratio, how do you judge whether it’s high or low? There are two most practical methods:

Horizontal comparison: compare with peers

P/E ratios vary greatly across industries. For example, the automotive industry might have a P/E of 98, while the shipping industry might only be 1.8. Comparing a car stock with a shipping stock is a waste of time.

The correct approach is to compare companies within the same industry and similar business models. For example, to evaluate TSMC’s P/E ratio, you should compare it with UMC, Powerchip, and other wafer foundry companies. If TSMC’s P/E is significantly higher than UMC’s, it might indicate that the market perceives TSMC as having stronger competitiveness or growth potential.

Vertical comparison: compare with its own history

Compare the current P/E ratio with the company’s P/E ratios over the past few years. Taking TSMC as an example, if the current P/E is in the “upper-middle range” of its five-year history—neither at bubble highs nor at recession lows—that usually indicates a relatively healthy valuation level.

P/E river map: see at a glance whether the stock price is high or low

Want to quickly judge whether a stock is overvalued or undervalued? There’s a visual tool called the P/E river map.

Its principle is simple: Stock Price = EPS × P/E ratio. Based on the historical maximum and minimum P/E ratios, we can draw parallel lines representing “reasonable stock prices” at different valuation levels.

Typically, 5 to 6 lines are drawn. The top line represents the stock price at the highest historical valuation, and the bottom line at the lowest. If the current stock price is below the lower zone, it usually indicates undervaluation and a potential buying opportunity; if above the upper zone, caution is advised.

It’s important to emphasize that a low P/E ratio often does mean a buying opportunity, but it doesn’t guarantee profits. Many factors influence stock prices, including market sentiment, industry cycles, policy changes, and more.

The “dark side” of the P/E ratio: its three major limitations

Investors like to use the P/E ratio, but they must be aware of its drawbacks:

1. Ignores a company’s debt

The P/E ratio only considers equity value, completely ignoring the company’s debt. Two companies with the same EPS might have very different risks—one financed with own capital, the other borrowing money. The latter is riskier and should be valued less. So, if they have the same P/E, it doesn’t mean one is cheaper than the other.

2. Difficult to define “high” or “low” precisely

A high P/E might just mean the company is temporarily cold, with short-term profit dips, but its fundamentals are sound, and the market believes it will recover. It could also mean the market is optimistic about its growth and is willing to buy early. Or it might simply be overhyped. Because of these scenarios, there’s no absolute standard like “high P/E = should not buy.”

3. Loss-making companies cannot be measured by P/E

Startups, biotech firms, and others that haven’t turned a profit yet cannot have a P/E ratio. In such cases, investors turn to other indicators like Price-to-Book ratio (PB) or Price-to-Sales ratio (PS).

PE, PB, PS—the three brothers—each has its use

Since the P/E ratio has limitations, what alternative indicators are there?

The P/E ratio is suitable for evaluating companies with stable profits; the PB ratio is better for cyclical industries; the PS ratio is used for valuation of companies without profits.

Investment tips

Once you grasp the basics of the P/E ratio, the key is to apply it flexibly in actual investing. The P/E ratio is an analysis tool, not a buy/sell signal. A low P/E is worth attention, but it must be combined with factors like growth potential, industry outlook, and financial health for comprehensive judgment. Remember, no single indicator can perfectly predict stock prices, and the P/E ratio is no exception.