Master the core principles of the Price-to-Earnings Ratio: A必修课 for stock valuation

In stock investing, the Price-to-Earnings (P/E) ratio is considered the most critical valuation reference tool. Many investment analysts frequently mention a company’s historical P/E levels and current stock price position to derive an ideal buying price range. What exactly is the P/E ratio, how is it applied in practical investing, what constitutes a reasonable high or low P/E, and what is the complete knowledge system behind it?

The Essential Definition of the P/E Ratio

The P/E ratio, also called the Price-to-Earnings ratio, abbreviated as PE or PER(Price-to-Earning Ratio), fundamentally reflects how long it takes for a stock’s current price to recover its cost. This indicator is widely used to assess whether a stock’s current price is undervalued or overvalued.

Simply put, if a company’s P/E ratio is 13, it indicates that the company needs 13 years to earn profits equivalent to its current market value, meaning investors need to wait about 13 years to recoup their investment through profits. Taking TSMC as an example, its P/E ratio is around 13, which represents the above meaning.

Two Calculation Paths for the P/E Ratio

There are generally two methods to calculate the P/E ratio: one is dividing the stock price by earnings per share (EPS), and the other is dividing the total market capitalization by net profit attributable to common shareholders. In practice, the first method is more commonly used.

For example, TSMC (2330.TW), assuming the current stock price is 520 NT dollars, and the EPS for 2022 is 39.2 NT dollars, then the P/E ratio = 520 ÷ 39.2 ≈ 13.3. This simple calculation allows investors to quickly gauge the stock’s valuation level.

The Three Major Classifications of the P/E Ratio

Based on the time dimension of the EPS data used, the P/E ratio can be divided into historical-based indicators and future expectation-based indicators. Among the historical types, there are two subcategories.

Complete classification of the P/E ratio: ◆ Historical P/E: Static P/E & Rolling P/E ◆ Forecasted P/E: Dynamic P/E

How to Understand Static P/E

The formula for static P/E is: PE = Stock Price ÷ Annual EPS

Annual EPS is usually disclosed when listed companies release their annual financial reports, or it can be obtained by summing the EPS of the past four quarters. For example, TSMC’s 2022 EPS = Q1 7.82 + Q2 9.14 + Q3 10.83 + Q4 11.41 = 39.2 NT dollars.

The reason this indicator is called “static” is that the annual EPS remains unchanged before the new annual report is released, and the PE fluctuation is entirely driven by stock price changes.

Application Scenario of Rolling P/E

Rolling P/E, also known as TTM (Trailing Twelve Months) P/E, uses the latest 12 months of data. Since listed companies release quarterly reports, in practice, it is the sum of EPS over the most recent four quarters.

Calculation: PE (TTM) = Stock Price ÷ Sum of EPS over the latest 4 quarters

For example, if TSMC’s latest Q1 2023 EPS is 5 NT dollars, then the sum of the latest four quarters’ EPS is: 22Q2 9.14 + 22Q3 10.83 + 22Q4 11.41 + 23Q1 5 = 36.38 NT dollars.

Thus, PE (TTM) = 520 ÷ 36.38 ≈ 14.3.

Compared to the static PE of 13.3 when the new quarter’s EPS is announced, the rolling PE updates to 14.3, better reflecting the latest profitability situation.

Features of Dynamic P/E Forecasting

Dynamic P/E refers to the P/E calculated based on estimated EPS, with the formula: PE = Stock Price ÷ Estimated Annual EPS

If a research institution forecasts TSMC’s 2023 EPS to be 35 NT dollars, then the dynamic PE = 520 ÷ 35 ≈ 14.9.

It is worth noting that different institutions’ EPS forecasts can vary significantly, and companies often tend to be optimistic or conservative in their profit predictions. This limits the reference value of dynamic P/E and can cause confusion in investment decisions.

To aid memory, here is a comparison of the three types:

Dual Framework for P/E Evaluation Standards

When encountering a certain P/E value, how to judge whether it is reasonable? The common approaches are mainly two: compare horizontally with industry peers, or compare vertically with the company’s own historical P/E.

Industry Horizontal Benchmarking

Different industries have vastly different characteristics, and the reasonable P/E range varies greatly. For example, data from a certain exchange in early 2023 shows that the PE of the automotive industry can reach 98.3, while the shipping industry is only 1.8. These two are clearly incomparable.

Therefore, when evaluating P/E, it is advisable to select peer companies within the same industry and similar business scope. For instance, comparing TSMC with UMC, Powertech, and other chip manufacturing companies.

Mid-April 2023 data shows TSMC’s PE around 13, UMC about 8, and Powertech about 47. TSMC’s P/E is at a moderate level and not considered overvalued.

Company Vertical Historical Benchmarking

Comparing the current P/E with the company’s past P/E trends allows for an intuitive judgment of whether the current valuation is high or low.

For example, TSMC’s current P/E is 13, which is below 90% of its P/E values over the past five years, indicating the current valuation is relatively cheap. Observing the historical fluctuations of the P/E curve on the stock price chart can help investors gain a clearer sense of positioning.

Practical Application of P/E in Investing

Using P/E River Map for Visual Judgment

The P/E river map is a visually appealing and practical tool that allows investors to intuitively understand the current stock price’s position relative to historical valuation levels. These charts typically display 5 to 6 parallel lines on a stock price candlestick chart, each generated based on: Stock Price = EPS × Corresponding P/E multiple.

The top line represents the price corresponding to the historical highest P/E, the bottom line the lowest P/E, and the middle lines the average or median levels.

Taking TSMC as an example, its latest stock price falls between the price bands corresponding to 13x and 14.8x P/E, indicating a relatively undervalued position. This position is often viewed as a favorable buying opportunity, but it is important to emphasize that this is only a valuation signal and does not guarantee profit after purchase.

Understanding the True Relationship Between P/E and Stock Price

An important realization is: There is no necessary causal relationship between P/E and stock price movements.

A low P/E stock does not necessarily rise, nor does a high P/E stock necessarily fall. The market assigns high valuations to certain stocks because market participants are optimistic about the company’s growth prospects. This explains why many tech stocks with high P/E ratios can still see their prices continue to rise.

Three Major Limitations of P/E Usage

As a common valuation tool, P/E is important but has obvious limitations in scope and accuracy:

Complete Ignorance of Debt Factors

Enterprise value comprises both equity and debt, but P/E calculations focus solely on equity, completely ignoring the company’s debt level. Two companies with the same P/E may have vastly different risks if one is asset-rich and the other heavily leveraged.

During economic cycles or changing interest rate environments, highly leveraged companies face greater pressure. Even if EPS is similar, low-debt companies usually enjoy higher stock prices. In such cases, it is incorrect to simply assume that high P/E companies are “cheaper.”

Ambiguity in High or Low P/E Definitions

High P/E can result from various reasons: perhaps the company faces short-term headwinds causing profit decline but fundamentals remain intact; or the market has strong expectations of future growth, leading to early capital deployment; or it could be a pure overvaluation correction.

These situations depend on specific characteristics of the target, making it difficult to mechanically judge whether the current P/E is high or low based solely on historical experience.

Inability to Value Non-Profit Companies

Many startups and biotech firms have yet to turn a profit, making P/E valuation impossible. In such cases, investors need to turn to other metrics, such as Price-to-Book (PB) ratio for asset valuation or Price-to-Sales (PS) ratio for revenue potential.

Quick Reference Table for PE, PB, PS

To facilitate quick reference, here is a comparison of three commonly used valuation metrics:

After understanding the core logic and calculation methods of P/E, investors can incorporate it into their stock selection system, seeking targets aligned with their risk appetite and return expectations. By rationally applying this tool and combining it with other fundamental analysis methods, the scientificity of investment decisions can be significantly improved.