The secret weapon for stock valuation: How to effectively use the Price-to-Earnings ratio formula?

Stock investments often hear financial advisors say, “This stock has a low Price-to-Earnings Ratio” or “That one has a too-high PE, be cautious,” but what exactly is the PE ratio talking about? Why is this indicator so important? Simply put, the PE ratio is a measure of whether a stock is cheap or expensive.

Starting with EPS: Understanding the Core of the PE Ratio

The PE ratio (PE or PER, full name Price-to-Earning Ratio) represents how many years it would take for the invested principal to be recovered through the company’s earnings. It is also called the Price-to-Earnings ratio and is the most commonly used tool for evaluating a company’s valuation.

Taking TSMC as an example, suppose the PE ratio is 13, which means, based on current profit speed, investors need to wait 13 years to break even. Looking at it from another angle, if the company’s earnings per share (EPS) is 39.2 NT dollars and the stock price is 520 NT dollars, it’s like buying the right to earn 39.2 NT dollars per year for 520 NT dollars—whether this is worth it or not, the PE ratio makes it clear.

PE Ratio Formula and Two Calculation Methods

The most common PE ratio calculation formulas are two:

Method 1: Stock Price ÷ EPS

This is the most straightforward method. For example, TSMC’s current stock price is 520 NT dollars, and its 2022 EPS is 39.2 NT dollars, so PE = 520 ÷ 39.2 = 13.3.

Method 2: Company Market Value ÷ Net Profit Attributable to Common Shareholders

Both methods are essentially the same, just from different perspectives—one from the stock perspective, the other from the company’s overall perspective. In practice, we usually use the first method.

Three Types of PE Ratios: Which One Should You Use?

Depending on the nature of EPS used, PE ratios are divided into historical PE and estimated PE.

Static Price-to-Earnings Ratio (Past)

Calculation: Stock Price ÷ Annual EPS

This uses the full-year profit of the previous year, making it the most stable but also the most lagging. For example, TSMC’s 2022 EPS = Q1 + Q2 + Q3 + Q4 = 7.82 + 9.14 + 10.83 + 11.41 = 39.2. Until the new annual report is released, this EPS remains fixed.

Rolling PE (TTM, Most Recent)

Calculation: Stock Price ÷ Sum of the latest 4 quarters’ EPS

TTM stands for “Trailing Twelve Months,” which reflects the company’s latest profit situation more timely. For example, if 2023 Q1 EPS is 5, then the latest 4 quarters are (22Q2 + 22Q3 + 22Q4 + 23Q1) = 9.14 + 10.83 + 11.41 + 5 = 36.38, so PE(TTM) = 520 ÷ 36.38 ≈ 14.3. This method overcomes the lag of static PE.

Dynamic PE (Future)

Calculation: Stock Price ÷ Estimated future EPS

Using analyst or institutional forecasts of future EPS. It seems to reflect the future, but the problem is that estimates vary among institutions, and companies can be over- or under-estimated, making this number less reliable.

What PE Ratio Is Reasonable? Two Perspectives for Judgment

When you see a PE ratio number, how do you determine if it’s cheap or expensive? The key is to compare it with the appropriate benchmark.

Horizontal Industry Comparison

PE ratios vary greatly across industries. According to Taiwan Stock Exchange data, the PE of the automotive industry can be as high as 98, while shipping is only 1.8. These are incomparable. So, comparison should be among companies within the same industry.

For example, taking TSMC, comparing it to UMC(PE=8) and Taiwan Cement(PE=47), we see TSMC’s PE=13 is between the two, indicating it’s not overvalued. That’s a proper comparison.

Vertical Historical Comparison

Compare the current PE with the company’s past PE ratios. If TSMC’s current PE is 13, and it’s below 90% of its past 5-year PE levels, it suggests the current valuation is relatively cheap and may be a good entry point.

Three Major Limitations of the PE Ratio: Things to Know Before Using

While useful, the PE ratio is not万能, and has three clear limitations.

Ignores Debt Factors

Enterprise value = Equity value + Debt. The PE ratio only considers equity, ignoring liabilities. Two companies with the same PE but different debt levels have very different risks. During economic downturns, highly leveraged companies face greater pressure. So, PE alone isn’t enough; asset-liability structure must also be considered.

Hard to Define High or Low Accurately

A high PE might be because the company faces short-term difficulties but has strong fundamentals, and the market is optimistic about its long-term prospects; or it might be due to short-term overvaluation; or because a growth industry is priced in advance. Each situation differs, making simple historical comparisons difficult.

Not Applicable for Startups and Loss-Making Companies

New startups or biotech firms with no profits have EPS of zero, so PE cannot be calculated. In such cases, valuation methods like Price-to-Book (PB) or Price-to-Sales (PS) are used instead.

The Differences Among PE, PB, and PS Valuation Tools

PE River Map: Visualizing Stock Valuation

Want a quick way to judge if a stock is over- or undervalued? The PE River Map is a good tool. It typically plots 5-6 lines on the stock price chart, each representing different multiples of PE:

Calculation logic: Stock Price = EPS × PE multiple

The lines are based on the highest historical PE and the lowest historical PE. The lower the stock price relative to these lines, the more undervalued it is.

For example, if TSMC’s stock price falls between PE 13 and PE 14.8, it’s in a relatively undervalued zone, often indicating a buying opportunity. But note, a low PE doesn’t guarantee the stock price will rise—market factors are complex, and this is just a reference signal.

Using the PE Formula for Stock Selection and Positioning

After understanding how to calculate and apply the PE ratio, investors can develop their own stock selection strategies. The core logic is: Look for stocks that are undervalued relative to industry averages or historical levels.

Although low PE stocks seem cheap, they may not necessarily rise in the future. Conversely, high PE stocks may not necessarily fall—many growth tech stocks have high PE ratios for a long time but continue to rise because the market is optimistic about their future growth potential.

Therefore, PE is just one dimension; combining it with company fundamentals, industry outlook, macro environment, and other analyses is essential for making smarter investment decisions.