Before investing, you need to master this key metric: how to interpret the P/E ratio like a professional

Have you ever seen a stock with a very low PER and thought it was a bargain, only to see it plummet months later? The problem isn’t the metric itself, but how you use it. The PER is probably the most misunderstood indicator in the markets, and we’ll learn why so many investors get it wrong.

The truth behind the PER: more than just a number

The PER (Price/Earnings Ratio, or Price/Earnings Ratio) is a measure that compares the price the market pays for a company with the actual money it earns. If a company has a PER of 15, it means that its current earnings (projected over 12 months) would recover the investment in 15 years.

Sounds simple, right? But this is where most fail. Many believe that a low PER always signals a good opportunity, when in reality, it’s much more nuanced.

Two ways to calculate, one same result

The PER can be calculated in two different ways, although both will give you the same information:

Option 1: Market capitalization ÷ Net profit
Option 2: Price per share ÷ Earnings per share (EPS)

The data is accessible to anyone. You don’t need a finance degree to get these numbers; you can find them on any financial platform in seconds.

The Meta and Boeing paradox: why PER doesn’t always work

Look at what happened with Meta (Facebook) between 2020 and 2022. While the PER steadily declined, the stock kept rising. Why? Because the company was generating increasing profits. It was the ideal situation: growing earnings and compressed multiple.

Then came late 2022 and everything changed. Meta still had a low PER, but the stock collapsed. Why? Because the Federal Reserve raised interest rates, and markets completely re-evaluated their appetite for tech. The PER remained attractive, but the market said “no thanks.”

In contrast, Boeing maintains its PER in relatively stable ranges while the stock swings violently. This shows that the PER is just one piece of the puzzle.

What the PER tells you (and what it DOESN’T)

A low PER generally indicates that a company is undervalued. A high PER suggests growth expectations or possible overvaluation. But this interpretation varies greatly depending on the sector.

ArcelorMittal, a steelmaker, trades with a PER of 2.58. Zoom Video, the videoconferencing platform, has a PER of 202.49. Does that mean Zoom is a bubble? Not necessarily. It means that the tech sector naturally commands higher multiples than heavy industry.

The quick guide to interpreting the PER

• PER 0-10: Superficially attractive, but beware: often reflects troubled companies
• PER 10-17: The comfort zone, where analysts see growth potential without excessive speculation
• PER 17-25: Evident growth or early warning sign
• PER +25: Speculative bets with very bullish projections

But remember: these figures are guides, not rules. Interpretation always depends on context.

Shiller’s PER: an alternative for skeptics

Some consider the traditional PER too narrow because it only looks at one year’s earnings. Shiller’s PER corrects this by using the average of profits over the last 10 years (inflation-adjusted).

The idea behind this is that 10 years of historical data are sufficiently robust to predict earnings for the next 20 years. It’s a smoother, less volatile tool, but also slower to react.

When PER becomes completely irrelevant

The normalized PER tries to be more accurate by considering the company’s actual financial health. Instead of just net earnings, it uses free cash flow, and adjusts for debt and liquid assets.

A real example? When Banco Santander bought Banco Popular for 1 euro, the PER didn’t capture reality: the deal involved assuming colossal debt that completely changed the financial equation.

Value Investing and PER: a natural relationship

Value investors like funds such as Horos Value Internacional or Cobas Internacional constantly seek companies with a depressed PER (7-8 versus sector averages of 14+). The idea is simple: buy good businesses at cheap prices.

But here’s the trick: “cheap” doesn’t automatically mean “good buy.”

The three traps of PER you must avoid

Trap 1: Comparing companies from different sectors. A bank with PER 8 isn’t comparable to a biotech with PER 60.
Trap 2: Ignoring cyclical companies. When a steel manufacturer is at the peak of its cycle, its PER is low (high earnings). During the downturn, PER spikes (low earnings). Price movement goes opposite to what PER suggests.
Trap 3: Forgetting that a low PER company might be cheap for a reason: poor management, obsolescence, or imminent insolvency.

The true usefulness of PER in your analysis

PER is excellent for quick comparisons between competitors in the same sector and geography. If you’re choosing between two Spanish banks, PER gives you an initial clue.

But never, ever base an investment solely on PER. Combine it with:

• EPS: Earnings per share
• P/B: Price to book ratio
• ROE: Return on equity
• ROA: Return on assets
• Cash flow: The true heart of any business

A solid fundamental analysis requires at least 10 minutes digging into the company’s core. Check what generates those profits. Is it the main business or a one-time asset sale?

The undeniable advantages (when used correctly)

PER is easy to obtain, easy to calculate, and extraordinarily efficient for quick comparisons within the same sector. It allows comparing companies even if they don’t pay dividends. That’s why it remains one of the top three metrics professionals consult.

The limitations you must accept

PER only captures one year’s earnings, making it blind to trends. It’s completely useless for companies with no earnings (startups, restructuring companies). It’s a static snapshot, not a movie of what’s to come. It also fails spectacularly with cyclical companies.

The verdict

PER is a practical and powerful tool, but not magic. It’s the key that opens the door to fundamental analysis, not the complete solution. A winning investment combines PER with other metrics, sector insights, management analysis, and, honestly, patience.

Remember: there are companies with excellent PER that went bankrupt, and companies with terrible PER that delivered huge returns. The difference lies in who did the analysis and when.