The market declines, PE ratio you need to know—A stock valuation tool favored by investors

When the stock market experiences a significant decline, many investors tend to follow suit and buy various stocks. However, they often wonder whether the current prices are truly worth it or if they should increase their portfolios now or wait for a better opportunity. If a decision to invest is necessary, tools to measure whether stocks are undervalued or overvalued are essential. The PE ratio, or Price-to-Earnings ratio, is one of the primary indicators that investors focus on first.

PE ratio—The measure of stock price relative to earnings

PE ratio, or Price per Earning ratio, is calculated by dividing the stock price by the earnings per share (EPS) (EPS) to determine how many years it would take for an investor to recover their investment through the company’s profits, assuming the company pays consistent dividends each year.

The meaning of the PE ratio is straightforward: the lower the PE, the cheaper the stock, and the shorter the payback period. A high EPS indicates a company’s strong ability to generate profits. Therefore, even if you buy a stock at a high price, the PE might still appear low because of the large denominator.

How to calculate PE ratio—easy for comparing different stocks

The calculation formula for PE is simple: PE = Stock Price ÷ EPS (Earnings Per Share)

Both factors play a crucial role:

Stock Price (Price) is the amount investors pay to purchase a share. The lower the purchase price, the lower the PE ratio.

Earnings Per Share (EPS) is the company’s net profit for the year divided by the number of shares outstanding. Choosing stocks with high EPS results in a lower PE because of the larger denominator.

Real-world example: An investor buys a stock at 5 baht per share, and at that time, the stock has an EPS of 0.5 baht. The PE ratio would be 10, meaning it would take 10 years (if EPS remains constant) for the investor to recover their investment of 5 baht through the company’s profits. After 10 years, the stock holding would turn into a profit, or the initial investment would be recovered.

Forward PE vs Trailing PE—use appropriately

When evaluating stocks, investors should be familiar with two popular PE types:

Forward PE (PE Forward) uses the current stock price divided by the projected future earnings. It provides a view of expected future profits. This method helps to see the company’s growth potential, but it has limitations: companies might underestimate future earnings to appear more attractive, or external analysts’ estimates may vary, causing confusion.

Trailing PE (PE Past) relies on actual past performance, using the last 12 months’ real earnings. This approach is popular because the data is certain and quick to calculate. However, its drawback is that past performance does not guarantee future results. Investors should base their decisions on the company’s ability to generate future profits.

PE has limitations—must be used with additional analysis

Although PE is a standard metric for comparing stock prices across the market, EPS is not constant over time.

Imagine an investor buys a stock at 5 baht with an EPS of 0.5 baht (PE 10 times), expecting to hold for 10 years. If halfway through, the company experiences rapid growth, expanding production and export markets, and EPS increases to 1 baht per share, the PE drops to 5. This means the payback period shortens to 5 years.

Conversely, if negative factors arise, such as trade disputes or damages, causing EPS to fall to 0.25 baht, the PE increases to 20. The investor would need to hold the stock for 20 years to recover their investment.

Therefore, PE should be used alongside trend analysis of profits and other company factors to reduce investment risks.

Summary—PE is one of the tools investors must learn

Successful investors do not rely on a single tool. In volatile markets, they often combine multiple analysis techniques. When the market declines sharply and presents opportunities to accumulate good stocks, using the PE ratio can help estimate whether the current price is suitable for accumulation or if it’s better to wait.

Now, investors understand what the PE ratio is, how to use it to evaluate stock value, and what points to be cautious about. PE becomes another tool that investors can study and apply to buy undervalued and quality stocks. Stay updated on market conditions with Gate.io Market News to keep pace with market movements at all times.