## Essential Knowledge for Stock Trading: What Does the Price-to-Earnings (PE) Ratio Really Mean?

If you're new to the stock market, you'll soon hear a term — **Price-to-Earnings Ratio (PE)**. Investment advisors often mention this indicator, saying that a company's PE ratio determines its stock price. It may sound mysterious at first, but understanding it isn't that complicated.

**The essence of the PE ratio is simple: it tells you how many years it would take to recover your investment through the company's profits at the current stock price.** In other words, it’s a measure of whether the stock you’re buying is "expensive" or "cheap."

## PE and EPS: An inseparable pair

To understand the PE ratio, you first need to know **Earnings Per Share (EPS)**. These two metrics are like twins — one represents the company's earning ability, and the other reflects the reasonableness of the stock price.

The calculation of the PE ratio is straightforward:

**PE = Stock Price ÷ EPS**

Or in another form:

**PE = Market Capitalization ÷ Net Profit**

For example, if a company's current stock price is 100 yuan, and last year's EPS was 5 yuan, then PE = 100 ÷ 5 = 20. This means, at the current profit rate, it would take 20 years to earn back the money spent on buying the stock.

## Three types of PE ratios, essential for beginner investors to distinguish

Here's a trap: **The PE ratio for the same company can vary depending on which EPS figure you use.**

**1. Static (Historical) PE**

Uses **EPS from the entire last year**, with the simplest formula:

**PE = Stock Price ÷ Annual EPS**

This method is stable but lagging. Until the new annual report is released, this number remains unchanged; only the stock price fluctuates.

**2. Trailing Twelve Months (TTM) PE**

An improved version that uses **the sum of EPS from the most recent four quarters**, providing fresher data:

**PE (TTM) = Stock Price ÷ Sum of EPS over the last 4 quarters**

This approach overcomes the lag of static PE but still cannot predict future performance.

**3. Forward (Estimated) PE**

The most imaginative type, based on **analyst forecasts of future EPS**:

**PE = Stock Price ÷ Estimated annual EPS**

It sounds promising, but there are issues — different institutions have varying forecasts, some optimistic, some pessimistic, and the accuracy is questionable. Many investors have suffered losses by blindly trusting these estimates.

## How low should PE be to be considered "cheap"? This question is more complex than you think

After obtaining a company's PE, the next question is: **Is this PE high or low?**

### Comparing with industry peers is the most practical method

PE ratios vary greatly across industries. Tech stocks often have high PE ratios (due to growth potential), while traditional manufacturing tends to have lower PE ratios. You can't compare the PE of a tech company directly with that of a shipping company — it makes no sense.

**The most reliable approach is to find several companies in the same industry with similar business models, see their PE ratios, and then judge where the target company's PE stands.**

### Look at historical trends

Compare the current PE with the company's PE over the past few years to get a sense. If the current PE is significantly lower than the average over the past five years, it might be undervalued; if higher, it could be overvalued.

**But be cautious:** A low PE historically might indicate the company is in trouble, not necessarily that it’s cheap. Underestimation and decline are sometimes just a thin line apart.

## PE River Map: A visual way to see if the stock price is reasonable

To judge whether a stock price is too high or low more intuitively, **PE River Map** is a useful tool. It plots 5-6 lines on a candlestick chart, each representing a "reasonable price" at different PE levels.

The formula is: **Stock Price = EPS × PE**

The top line is calculated using the historical maximum PE, and the bottom line using the historical minimum PE. If the current stock price is in the upper half of this channel, it might be overvalued; in the lower half, it could be undervalued.

When the stock price drops to the "river" bottom, it often attracts bottom-fishers. But **don’t be fooled by this tool** — even if technical analysis shows undervaluation, it doesn’t guarantee the stock will rise immediately.

## Is a lower PE always better? Don’t be naive

This is the most common misconception. **Low PE ≠ guaranteed profit, high PE ≠ guaranteed loss.**

Some companies have high PE because the market is optimistic about their growth prospects and is willing to pay a premium for the "future." Many tech unicorns are like this — high PE but still rising.

Some companies have low PE because:
- The company is experiencing difficulties, and profits may continue to decline
- The industry is in a downturn
- The market is pessimistic about the company's future

Therefore, **don’t blindly trust PE numbers; understand what’s behind the PE.**

## The three fatal flaws of PE

### 1. Ignores debt issues

PE only considers equity value and ignores corporate debt. Two companies with the same PE can have vastly different risk profiles — one operates with its own funds, the other is heavily leveraged. During economic downturns or rising interest rates, high-debt companies face greater pressure.

### 2. Difficult to define "high" and "low"

This isn’t just simple math. A high PE might be due to short-term difficulties depressing profits but with a solid company; it could also be because the market expects long-term growth; or it might just be hype. **Judgment must be based on specific circumstances.**

### 3. Useless for loss-making companies

Startups, biotech firms, and other companies without profits have negative or zero EPS, making PE impossible to calculate. In such cases, other indicators like **Price-to-Book (PB)** or **Price-to-Sales (PS)** ratios should be used.

## EPS, PE, PB, PS: Four indicators with their own uses

| Indicator | Meaning | Formula | Suitable for |
|------------|---------|---------|--------------|
| EPS | Earnings Per Share | Net Profit ÷ Number of Shares | Measuring company's profitability |
| PE (Price-to-Earnings) | Market P/E Ratio | Stock Price ÷ EPS or Market Cap ÷ Net Profit | Mature, stable-profit companies |
| PB | Price-to-Book Ratio | Stock Price ÷ Book Value per Share | Cyclical industries, asset-heavy companies |
| PS | Price-to-Sales Ratio | Stock Price ÷ Revenue per Share | Companies with no profits or losses |

## One sentence summary

**The PE ratio is a quick reference for stock valuation, but it’s not the only criterion.** It’s useful for excluding obviously overvalued or undervalued stocks, but making investment decisions requires analyzing fundamentals, growth potential, industry outlook, and more. Use PE as a tool, not a belief.