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

In the stock market, if you want to determine whether a stock is expensive or cheap, the Price-to-Earnings Ratio (PE or PER) is undoubtedly the most critical valuation tool. Many successful investors regard it as the first screening criterion for selecting stocks, but many novice investors feel confused by it. This article will start from zero, guiding you to deeply understand the core value, calculation logic, and how to flexibly apply the PE ratio in practical scenarios.

What exactly does the PE ratio measure?

The Price-to-Earnings Ratio (abbreviated as PE or PER in English, full name: Price-to-Earning Ratio), is one of the most widely used valuation indicators in investment analysis.

Simply put, the PE ratio answers a core question: With the current profitability, how many years will it take for this company to earn back its current market value? Another way to understand it is: If you buy this stock today, how many years will it take to recover your principal through the company’s earnings?

For example, TSMC’s PE ratio is about 13 times. This means that under the current stable profit level, investors need to wait about 13 years for the company’s net profit to equal its current market capitalization. Conversely, this also implies the current stock price of TSMC is at a certain valuation relative to its earning power.

How to calculate the PE ratio step by step?

The calculation of the PE ratio may seem complex, but there are only two main methods:

Method 1 (most common): Divide the current stock price by earnings per share (EPS)

$$PE = Stock Price ÷ EPS($$

Method 2: Divide the company’s total market value by net profit attributable to common shareholders

$$PE = Company Market Value ÷ Net Profit Attributable to Shareholders$$

Let’s demonstrate with actual data. Suppose TSMC’s current stock price is NT$520, and its EPS for 2022 is NT$39.2, then:

$$PE = 520 ÷ 39.2 = 13.3 times$$

This means, based on the 2022 profit level, this stock’s PE is 13.3 times.

Are there different categories of PE ratios? Understand the three main types

Many beginners don’t realize that, depending on the source of the EPS data used, the PE ratio can be divided into three completely different categories, each with its own specific use and limitations.

) Static PE Ratio: Based on past year’s earnings

The static PE ratio uses EPS data from the entire previous year. The calculation is straightforward:

$$Static PE = Stock Price ÷ Annual EPS$$

For example, to calculate TSMC’s static PE for 2022, sum the EPS of all four quarters:

$$Annual EPS = Q1###7.82( + Q2)9.14( + Q3)10.83( + Q4)11.41( = 39.2 NT$$$

The characteristic of the static PE is that it is relatively “stable”—since the annual EPS won’t change before the new annual report is released, the PE fluctuation depends entirely on stock price movements. This is why it is called “static.”

Advantages: Data comes from publicly available financial statements, highly credible
Disadvantages: Reflects past performance; may not be timely for rapidly changing companies

) Rolling PE Ratio: Dynamic, updated quarterly

The rolling PE uses the concept called TTM (Trailing Twelve Months), meaning it continuously uses the latest four quarters’ EPS for calculation.

$$Rolling PE###TTM( = Stock Price ÷ Sum of latest 4 quarters EPS$$

Suppose TSMC announced Q1 EPS of NT$5 in Q1 2023, then the latest 4-quarter EPS would be:

$$Latest 4 quarters EPS = Q2)9.14( + Q3)10.83( + Q4)11.41( + Q1)5( = 36.38 NT$$$

$$Rolling PE = 520 ÷ 36.38 ≈ 14.3 times$$

Notice an interesting phenomenon: the static PE remains at 13.3, but the rolling PE has risen to 14.3. This is because the new quarter’s EPS has been included in the calculation.

Advantages: Overcomes the lag of static PE, better reflects recent 12 months’ actual earnings
Disadvantages: Still cannot predict future earnings trends

) Dynamic PE Ratio: Based on future earnings forecasts

The dynamic PE (also called estimated PE) uses predicted future EPS by research institutions or analysts.

$$Dynamic PE = Stock Price ÷ Estimated Annual EPS$$

For example, if an analyst estimates TSMC’s full-year EPS for 2023 to be NT$35, then:

$$Dynamic PE = 520 ÷ 35 ≈ 14.9 times$$

However, a major issue is: Different institutions have different estimates, and even the same institution’s estimates can change over time. Sometimes forecasts are overly optimistic, other times overly pessimistic, which often causes confusion among investors.

Advantages: Forward-looking, reflects potential future profitability
Disadvantages: Forecasts are often inaccurate, reducing practical reliability

A comparison table of the three PE types

How to determine what PE ratio is “cheap”? The golden rule of judgment

Looking at a single number often has no meaning. Whether a stock’s PE is high or low must be evaluated within a specific comparison framework.

Rule 1: Horizontal comparison with industry peers

PE ratios vary greatly across industries. For example, according to data released by Taiwan Stock Exchange in February 2023:

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

Clearly, directly comparing companies from these two industries is absurd. Therefore, comparing within the same industry is the proper approach.

Taking TSMC as an example, we should compare it with other semiconductor manufacturers:

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

From this, we see TSMC’s valuation is in the middle range among peers, not particularly expensive, providing a relatively objective benchmark.

Rule 2: Vertical comparison with past performance

Another method is to look at the company’s historical PE performance. Comparing its PE at different times can help us judge whether the current valuation is undervalued.

For example, if we look at TSMC’s PE trend over the past five years, and find that the current PE of 13 times is lower than 90% of its PE values in that period, it indicates that relative to its history, the current valuation is indeed low, possibly a good time to invest.

The PE river chart: instantly see the stock price high or low

Besides numerical comparison, the PE river chart is a more intuitive visual tool that allows investors to instantly judge whether a stock is overvalued or undervalued.

The principle of the river chart is based on the formula:

$$Stock Price = EPS × PE multiple$$

The chart typically displays 5 to 6 parallel lines, each representing different PE multiples:

• Top line: Calculated with the highest historical PE (overvalued zone)
• Middle line: Calculated with average PE (fair valuation zone)
• Bottom line: Calculated with the lowest historical PE (undervalued zone)

When the stock price falls to the lower lines on the river chart, it usually indicates the stock is undervalued and may be a good buying opportunity. Conversely, when it reaches the upper lines, it may be overvalued.

Does a low PE necessarily mean the stock will rise, or a high PE mean it will fall?

This is a common misconception among beginners. A stock with a low PE does not necessarily mean it will rise in the future, and a high PE does not guarantee it will fall.

Why? Because the market’s willingness to assign higher valuations to certain companies is often based on optimistic expectations about their future prospects. Many tech stocks have high PE ratios but continue to hit new highs because the market believes their earnings will grow significantly.

Therefore, the PE ratio is just a valuation tool, not a crystal ball predicting stock prices. It can tell you whether a stock is “cheap,” but it cannot guarantee profits after purchase.

The three major limitations of the PE ratio: risks you must know

Although the PE ratio is an important valuation reference, it is not perfect. When using it, you must be aware of the following three significant limitations:

Limitation 1: Ignores the company’s debt structure

The PE ratio only considers net profit and stock price, completely ignoring the company’s debt. Two companies with the same profit can have vastly different risk profiles if one is financed mainly by equity and the other by debt.

In economic downturns or rising interest rate environments, highly leveraged companies face greater pressure. Therefore, stocks with the same PE but lower debt levels should be valued higher. This is why relying solely on PE cannot provide a complete valuation conclusion.

Limitation 2: Difficult to accurately judge whether PE is high or low

A high PE for a company can have multiple reasons:

• It might be temporarily in trouble, but its fundamentals are intact, and the market expects recovery
• It might be due to investors’ anticipation of significant future earnings growth, making the high PE reasonable
• It could also be a speculative bubble that needs correction

Because the reasons are complex, relying solely on historical experience to judge whether a PE is high or low often leads to errors.

Limitation 3: Cannot evaluate unprofitable companies

Many emerging industries, such as biotech firms or startups not yet profitable, have little or no earnings, making it impossible to calculate a meaningful PE. In such cases, investors need to turn to other valuation tools.

Going beyond PE: understanding PE, PB, PS three brothers

The PE ratio is just one of many valuation tools. When PE is not applicable, we have other options:

Choosing the appropriate valuation metric is wiser than blindly relying on a single indicator.

From knowledge to practice: how to use PE for stock selection

After mastering the calculation and theory of PE, the next step is to incorporate it into your investment system:

1. Establish benchmarks: Study the industry you’re interested in to understand its average PE level
2. Horizontal comparison: Compare the PE of your target stock with its industry peers
3. Vertical analysis: Review the historical PE trend of the target stock to assess its current valuation position
4. Combine with other tools: Don’t rely solely on PE; consider PB, PS, financial health, and other factors
5. Regular review: As quarterly and annual reports are released, update the PE and monitor changes

Only by systematically applying the PE ratio can you gain more control in stock investing.