Understand the meaning of P/E ratio and master the core key to stock valuation

When investing in stocks, the Price-to-Earnings Ratio (PE) is a core valuation tool that must be understood. Many investors still have some confusion about “PE meaning” and don’t know how to use this indicator to judge a stock’s true value. In fact, PE is not mysterious; once you understand its principles and calculation methods, even beginners can quickly get started.

PE Meaning: Understanding this Key Indicator in One Sentence

PE (or PER) simply represents: how many years it takes to recover your investment through the company’s earnings.

From another perspective, PE is a measure of whether a stock is “expensive or cheap.” For example, if a stock’s PE is 15, it means the company needs 15 years to earn its current market value, or you need 15 years to recoup your investment through its profits.

PE is also called Price-to-Earnings Ratio, the most common valuation method in the stock market. It tells investors whether the current stock price is reasonable relative to the company’s earning power.

How to Calculate PE: Two Easy Formulas

Calculating PE is straightforward, mainly using two methods:

Method 1: Stock Price ÷ Earnings Per Share (EPS)

This is the most common calculation. For example, if a stock’s current price is 500 yuan and its EPS is 25 yuan, then PE = 500 ÷ 25 = 20.

Method 2: Total Market Capitalization ÷ Total Net Profit

The result is the same, just using the company’s overall data.

Real case example: TSMC (2330.TW) stock price is 520 yuan, EPS in 2022 was 39.2 yuan, so PE = 520 ÷ 39.2 ≈ 13.3. This means that at the current price, it takes about 13 years to recover the investment in TSMC.

Types of PE: Understanding the Three Main Types

In actual investing, because of different earnings data used, PE is divided into three types:

Static PE — Based on past earnings

Calculation: Stock Price ÷ Annual EPS

Static PE uses the company’s reported earnings from the previous year. For example, TSMC’s 2022 EPS is the sum of four quarters: 7.82 + 9.14 + 10.83 + 11.41 = 39.2.

This data is relatively stable; PE will change with stock price fluctuations, hence called “static.” Its advantage is that the data is accurate and reliable; the disadvantage is that it can lag, especially during rapid economic changes.

Rolling PE — Reflects the latest 12 months’ performance

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

Rolling PE is also called TTM (Trailing Twelve Months), meaning it uses the latest 12 months’ data. Since listed companies release quarterly reports, it sums the latest four quarters’ EPS.

For example, if TSMC’s EPS in Q1 2023 is 5 yuan, then the latest 4 quarters = 9.14 + 10.83 + 11.41 + 5 = 36.38, so PE(TTM) = 520 ÷ 36.38 ≈ 14.3.

This method is more timely than static PE and better reflects the company’s recent profitability.

Dynamic PE — Based on expected future earnings

Calculation: Stock Price ÷ Estimated annual EPS

Dynamic PE uses analyst forecasts of future earnings. If the forecast EPS for TSMC in 2023 is 35 yuan, then dynamic PE = 520 ÷ 35 ≈ 14.9.

However, note that estimates from different institutions can vary greatly, and forecasts are prone to errors, so this data has relatively lower reference value.

What Is a Reasonable PE: Two Judgment Approaches

When seeing a PE number, how do you know if it’s high or low? Mainly by two methods:

Industry Comparison: Horizontal comparison is the most direct

PE ratios vary greatly across industries. For example, in Taiwan’s 2023 stock market data, the PE of the automotive industry might be as high as 98, while shipping might be only 1.8. So, cross-industry comparison is not appropriate.

The correct approach is to compare with peers in the same industry or similar business types. For example, TSMC (PE 23.85) versus UMC (PE 15). Such comparison makes sense. It shows TSMC’s valuation is relatively higher, often reflecting market optimism about its prospects.

Vertical Analysis: Comparing with the company’s own history

Compare the current PE with the company’s past few years’ PE to see where the current valuation stands.

Taking TSMC as an example, its current PE of 23.85 is in the mid-to-upper range of the past five years, neither at the bubble high nor below the low, indicating the stock is in a reasonable recovery phase, reflecting moderate market optimism about its future.

PE River Map: Visualizing Valuation Levels

To intuitively judge whether a stock is expensive or cheap, you can use a PE river map. This chart overlays 5 to 6 lines on the stock price chart, each line calculated as: Stock Price = EPS × PE.

The top line corresponds to the highest historical PE, and the bottom line to the lowest PE.

For example, if TSMC’s current price is between the 3rd and 4th lines, it indicates a relatively undervalued level, possibly a good buying opportunity. But remember, low valuation doesn’t guarantee profits; you still need to consider fundamentals, industry trends, and other factors.

PE and Stock Price Movements Are Not Absolutely Correlated

This is a common misconception among beginners. A low PE stock doesn’t necessarily go up, and a high PE stock doesn’t necessarily go down.

Market willingness to assign higher valuation often reflects confidence in the company’s future growth potential. That’s why many tech stocks have high PE but their prices keep rising—the market believes they are worth that price. Conversely, some traditional industries with low PE may continue to decline.

Limitations of PE: Three Important Drawbacks to Know

Although PE is useful, it has clear limitations:

1. Ignores the company’s debt risk

PE only considers equity value and ignores debt. Two companies with the same PE can have very different risk profiles—one financed mainly by equity, the other heavily leveraged.

When interest rates rise or during economic downturns, highly leveraged companies face greater pressure. So, when comparing PE, also consider their debt ratios.

2. The definition of high or low PE is vague

A high PE can indicate various situations: the company is temporarily cold but fundamentally sound, has strong growth prospects, or is a speculative bubble. Each case has different investment implications, making it hard to judge with a single standard.

Therefore, avoid simply saying “PE high means no buy” or “PE low means buy.” Instead, analyze the company’s specific situation.

3. Not applicable to loss-making companies

Startups, biotech firms, and many unprofitable companies cannot calculate PE. In such cases, use other valuation metrics like Price-to-Book (PB) or Price-to-Sales (PS).

The Differences and Uses of PE, PB, and PS

In practical investing, depending on the company’s characteristics, different valuation metrics are used:

Once you understand the meaning of PE, you can evaluate stocks more scientifically, avoiding blindly chasing high prices or panicking excessively. But remember, investment decisions should never rely on a single indicator; always analyze multiple data points and the company’s growth prospects.