The essential guide to Price-to-Earnings Ratio for stock investing: From zero basics to practical application

When investing in stocks, determining whether a stock is cheap or expensive is essential. The Price-to-Earnings Ratio (PE) is undoubtedly the most practical reference tool. Many analysts mention historical PE levels, current stock price positions, and then infer a reasonable entry price. So, what exactly does the PE represent? How is it calculated? And how can it be applied in actual stock selection? This article will guide you to a deep understanding of this important indicator.

What is the Price-to-Earnings Ratio? Core Concept Breakdown

The PE ratio, also known as the Price-to-Earnings Ratio, is the complete English name for Price-to-Earnings Ratio. Its core meaning is: using the current stock price to measure how many years it would take for the company to earn back its market value. In other words, it indicates how many years an investor needs to wait to recover their investment through company profits.

For example, TSMC currently has a PE of about 13 times, which means that at the current profit rate, it would take 13 years of net profit for the company to equal its current market value; from an investor’s perspective, buying TSMC stock requires 13 years to recover the investment through company earnings.

The logic of high or low PE and stock price valuation: A lower PE generally indicates a relatively cheap stock, and the market’s expectations for its future may be more conservative; a higher PE suggests the market is willing to pay a premium, possibly due to bright prospects or outstanding growth rates, resulting in a higher stock price.

How to Calculate the PE? Master Two Methods at Once

There are two main ways to calculate the PE: one is stock price divided by earnings per share (EPS), and the other is total company market value divided by net profit attributable to shareholders. In practice, the first method is most commonly used.

Taking TSMC as an example, suppose the stock price is NT$520, and the EPS for 2022 is NT$39.2, then PE = 520 ÷ 39.2 ≈ 13.3 times. This calculation is straightforward: the higher the stock price or the lower the EPS, the higher the PE; vice versa.

Different sources of EPS data can lead to different PE results, which introduces various classifications of PE ratios.

The Three Types of PE Ratios: Static, Rolling, and Forward

Based on the time scope of the EPS data used, PE ratios can be subdivided into three types, each with different application scenarios:

Static PE Ratio: Based on annual financial reports, a historical indicator

Calculation formula: Stock Price ÷ Annual EPS

Static PE uses the full-year EPS data published in the company’s annual financial report. For example, TSMC’s 2022 annual EPS can be obtained by summing the four quarterly EPS: Q1 (7.82) + Q2 (9.14) + Q3 (10.83) + Q4 (11.41) = NT$39.2.

Since the annual EPS remains fixed before the new year report is released, the PE fluctuation is entirely due to stock price changes, hence the name “static.” This indicator is lagging but the most authoritative.

Rolling PE (TTM): Reflects the latest 12 months dynamically

Calculation formula: Stock Price ÷ Sum of latest 4 quarters EPS

Rolling PE, also known as TTM (Trailing Twelve Months), uses the latest four quarters’ EPS sum as the denominator. Because listed companies release quarterly reports, this method can more timely reflect recent profitability.

Suppose TSMC reports a Q1 2023 EPS of NT$5, then the latest 4 quarters total = 22Q2 (9.14) + 22Q3 (10.83) + 22Q4 (11.41) + 23Q1 (5) = NT$36.38, so PE = 520 ÷ 36.38 ≈ 14.3 times.

Compared to the static PE of 13.3, the rolling PE of 14.3 is more up-to-date, better reducing lag, but still cannot predict future trends.

Forward PE: Based on forecasted EPS, a forward-looking indicator

Calculation formula: Stock Price ÷ Estimated future annual EPS

Forward PE uses analyst forecasts of future EPS to evaluate valuation proactively. For example, if an analyst estimates TSMC’s 2023 EPS at NT$25, then forward PE = 520 ÷ 25 = 20.8 times.

However, due to differences in forecasts among analysts and potential optimistic or conservative biases from the company itself, this indicator’s reliability is relatively low, limiting its practical use.

Comparison summary of the three PE types:

What PE is Reasonable? Two Main Judgment Dimensions

Looking at the absolute value of PE alone is not very meaningful; comparison is necessary to judge whether it is high or low. Common benchmarking methods include:

Industry Horizontal Comparison

PE ratios vary greatly across industries. According to Taiwan Stock Exchange data in 2023, the PE of the automotive sector reaches as high as 98.3, while the shipping industry is only 1.8—obviously, these two industries cannot be directly compared.

Therefore, a reasonable approach is to only compare PE ratios within the same industry, preferably among companies with similar business models. For example, TSMC should be compared with UMC, Powerchip, etc. As of now, TSMC’s PE is 23.85, UMC’s PE is 15, indicating TSMC’s PE is relatively high.

Vertical Historical Comparison

Comparing the current PE with the company’s historical PE allows quick assessment of valuation levels. TSMC’s current PE of 23.85 is in the “upper middle” position within its five-year history—neither reaching bubble highs nor falling into recession lows, showing a healthy recovery trend.

Practical Application: How to Use PE to Guide Buying and Selling Decisions

PE River Chart: Intuitive Judgment of Overvaluation and Undervaluation

The PE river chart visualizes PE data, helping investors quickly see valuation levels. The chart typically consists of 5 to 6 parallel lines, each calculated as: Stock Price = EPS × PE multiple.

The top line represents the highest historical PE corresponding stock price, the bottom line the lowest. Middle lines indicate different moderate PE levels.

For TSMC, if the current price is between the purple line (around PE 13) and the blue line (around PE 14.8), it suggests undervaluation, often considered a good buying point. However, it’s important to emphasize that low PE alone is just one technical condition; stock price movement ultimately depends on many factors.

PE and Price Movements Are Not Causally Linked

It’s crucial to note that a low PE does not necessarily mean the stock price will rise, nor does a high PE predict a decline. The market’s willingness to assign high valuations to certain companies often stems from optimistic outlooks. Many tech stocks, despite high PE ratios, continue to rise.

Investors should treat PE as one of several evaluation tools, not the sole decision factor.

Limitations and Precautions in Using PE

Although PE is widely used, it has obvious limitations:

Cannot Measure Corporate Debt Risk

PE only considers equity value, completely ignoring a company’s debt burden. Two companies with the same PE but different capital structures—one financed mainly by equity, the other heavily leveraged—face very different risks during economic fluctuations or interest rate changes. Sound capital structure should command higher valuation; thus, a low PE does not necessarily mean cheap.

Difficult to Define High or Low PE Accurately

A high PE may result from various scenarios: a company facing short-term headwinds causing profit decline but with solid fundamentals; or a company with bright growth prospects that the market has already priced in; or simply overvaluation needing correction. These situations are diverse, making it hard to judge whether the current PE is excessively high based solely on historical experience.

Cannot Evaluate Non-Profit Companies

Many startups or biotech firms have not yet achieved profitability, making PE calculation impossible. In such cases, investors should turn to other indicators like Price-to-Book (PB) or Price-to-Sales (PS).

The Difference Between PE, PB, and PS and Their Application Scenarios

Below is a comparison of three commonly used valuation metrics:

Once you grasp the concepts, calculation methods, and application scenarios of PE, you can more rationally select stocks, aligning with your investment preferences. Different financial tools offer diverse trading options, allowing investors to adapt flexibly according to risk tolerance and market conditions to achieve their return goals.