Stock Investment Must-Learn: How to Determine if a Stock Price is High or Low Using Price-to-Earnings Ratio (PE)

In stock investing, the Price-to-Earnings Ratio (PE) is a core indicator for assessing whether a company’s stock price is reasonable. Whether you’re a professional investor or a newcomer to the market, understanding this concept is essential. So, what exactly is the PE ratio, how is it calculated, when is it considered cheap, and when is it considered expensive? This article provides a comprehensive explanation.

The English Name and Definition of the PE Ratio

The full English name of the PE ratio is Price-to-Earnings Ratio, abbreviated as PE or PER, and it is also called the Price-to-Earnings (P/E) ratio in Chinese. Its core meaning is: how many years of profit are needed to recover the investment. In other words, this indicator intuitively reflects the valuation level of the current stock price relative to the company’s profitability.

For example, if a company’s PE ratio is 13, it means that you need 13 years of the company’s profits to recover your investment. Conversely, it indicates that the company would take 13 years to earn back its current market value.

A simple rule of thumb for judging PE ratios: The lower the PE, the generally cheaper the stock; the higher the PE, the more the market is willing to pay a premium, often due to investors’ expectations of the company’s future growth.

Two Methods of Calculating the PE Ratio

There are two standard formulas for calculating the PE ratio:

Method 1: Stock Price ÷ Earnings Per Share (EPS)
This is the most commonly used method. Suppose a company’s current stock price is 520 yuan, and its EPS for the previous year was 39.2 yuan, then PE = 520 ÷ 39.2 = 13.3 times.

Method 2: Total Market Capitalization ÷ Net Profit Attributable to Common Shareholders
This method yields the same result as Method 1 but from a different perspective.

Most investors prefer the first method because it is simpler and more intuitive.

Three Classifications and Calculation Methods of the PE Ratio

Based on the time frame of the earnings data used, the PE ratio can be divided into historical PE and estimated PE.

Static Price-to-Earnings Ratio (a static version of the historical PE)

Calculation formula: PE = Stock Price ÷ Annual EPS

Here, EPS refers to the profit data of the previous full year, usually announced when the company releases its annual report. Since annual profit data remains unchanged before the new annual report is published, the PE fluctuation is entirely due to stock price changes, hence the name “static.”

For example, if a company’s EPS for 2022 is calculated as Q1 + Q2 + Q3 + Q4 = 7.82 + 9.14 + 10.83 + 11.41 = 39.2 yuan.

Rolling Price-to-Earnings Ratio (a dynamic version of the historical PE, also called TTM)

Calculation formula: PE(TTM) = Stock Price ÷ Sum of EPS over the latest four quarters

TTM stands for “Trailing Twelve Months,” meaning a 12-month period. Since listed companies disclose quarterly reports, the actual calculation uses the latest four quarters’ earnings data.

This method’s advantage is its quick update speed, reflecting the company’s recent operational status in a timely manner, overcoming the lag of static PE.

Suppose the current stock price is 520 yuan, and the EPS for the latest four quarters are: Q2 (9.14) + Q3 (10.83) + Q4 (11.41) + Q1 (5) = 36.38 yuan, then PE(TTM) = 520 ÷ 36.38 = 14.3 times.

Dynamic Price-to-Earnings Ratio (Estimated PE)

Calculation formula: PE = Stock Price ÷ Estimated Annual EPS

This is based on forecasts by research institutions or analysts of the company’s future earnings. For example, if an analyst estimates that a company’s EPS for 2023 will be 35 yuan, and the current stock price is 520 yuan, then the dynamic PE = 520 ÷ 35 = 14.9 times.

Note: Due to significant differences in forecasts among various institutions and the tendency for estimates to be overly optimistic or conservative, the practical use of dynamic PE is relatively weak and can lead to confusing investment decisions.

What PE Ratio Is Considered Reasonable

Judging whether a company’s PE ratio is reasonable mainly involves two reference dimensions:

Industry Benchmark Comparison

Different industries have vastly different business models, and their PE levels vary significantly. For example, the automotive industry might have a PE of 98, while the shipping industry might only have 1.8; these cannot be directly compared.

Therefore, comparisons should only be made within the same industry, preferably among companies with similar business types. For instance, compare a chip manufacturer with other chip manufacturers.

Company Historical Vertical Comparison

Compare the current PE with the company’s historical data over the past few years to determine whether it is overvalued, fairly valued, or undervalued.

If the company’s PE is at the upper-middle level of its five-year history, it indicates that the stock price is between a bubble peak and a recession trough, usually representing a normal growth recovery phase.

PE River Chart: Visual Judgment of Stock Price High or Low

The PE river chart is a visualization tool that allows investors to intuitively see whether the current stock price is overvalued or undervalued.

The principle is simple: Stock Price = EPS × PE

The chart typically displays 5 to 6 curves representing the historical maximum PE, minimum PE, and several intermediate levels corresponding to stock prices. The current stock price position can visually reflect the valuation status:

• Located in the upper area → Stock price is overvalued
• Located in the middle area → Stock price is reasonable
• Located in the lower area → Stock price is undervalued, possibly a buying opportunity

Three Major Limitations of the PE Ratio

Although the PE ratio is a commonly used tool in investment analysis, it is not perfect:

1. Ignores the company’s debt level

The PE ratio only considers equity value and does not include corporate debt. Two companies with the same PE may have vastly different risks if one has ample assets and the other is highly leveraged. During economic cycles or interest rate changes, highly leveraged companies face greater risks.

2. Difficult to accurately determine high or low

A high PE may result from various reasons: the company is temporarily struggling but has good long-term prospects, the market has already priced in future growth, or it is simply overhyped and needs correction. In such cases, it is difficult to judge whether the current valuation is over or under.

3. Cannot evaluate unprofitable companies

Startups and biotech firms often have not yet achieved profitability, making PE calculation impossible. In these cases, other valuation metrics such as Price-to-Book (PB) or Price-to-Sales (PS) ratios should be used.

The Difference Between PE and Other Valuation Metrics

Practical Application Recommendations

Once you master the PE ratio and its English name, investors can apply it flexibly when selecting stocks:

1. Quick Screening Stage: Use PE to preliminarily judge whether the stock price is within a reasonable range
2. In-Depth Analysis Stage: Combine with PB, PS, and other indicators for comprehensive evaluation
3. Dynamic Monitoring Stage: Regularly observe the rolling PE changes to promptly detect improvements or deteriorations in company performance

Remember, the PE ratio is only a reference tool, not a decision endpoint. Many factors influence stock prices; a low PE does not guarantee a rise, and a high PE does not guarantee a fall. Rational investing is the foundation for long-term profits.