The key to stock valuation: Interpreting the investment value of the Price-to-Earnings ratio

When it comes to stock investing, many people have heard of the term “Price-to-Earnings Ratio,” but few truly understand how it can help us make investment decisions. The Price-to-Earnings Ratio, also known as the P/E ratio (short for PE or PER), is one of the most core indicators for judging whether a stock is worth buying. This article will start from basic concepts to help you comprehensively master this essential investment tool.

What Does the P/E Ratio Actually Represent?

Simply put, the P/E ratio reflects how many years it would take for the company’s earnings to recover the investment. It also intuitively shows us the current stock price relative to the company’s profitability.

Taking TSMC as an example, if its P/E ratio is 13, it means that at the current stock price, it would take 13 years to recoup the invested capital through the company’s annual earnings. The lower this multiple, the generally cheaper the stock; the higher the multiple, the more the market assigns a higher valuation expectation, which may stem from the company’s growth potential or development prospects.

In practical applications, investors can use the P/E ratio to quickly evaluate two questions: Is the current stock price reasonable? How does the valuation level compare to the past?

Three Methods to Calculate the P/E Ratio You Must Master

Static P/E Ratio: Past Data Speaks

Calculation formula: PE = Stock Price ÷ Annual EPS (Earnings Per Share)

Annual EPS is usually released when the company announces its annual report. For example, for TSMC in 2022, sum the EPS of the four quarters: Q1 EPS is 7.82 yuan + Q2 is 9.14 yuan + Q3 is 10.83 yuan + Q4 is 11.41 yuan = 39.2 yuan. If the stock price at that time was 520 yuan, then the static P/E ratio = 520 ÷ 39.2 = 13.3 times.

The advantage of the static P/E ratio is that the data is certain and unchanging; the downside is its lagging nature—it reflects past profit levels and cannot predict future trends.

Rolling P/E Ratio: Real-Time Reflection of the Latest 12 Months

This type of P/E ratio is also called TTM P/E ratio (Trailing Twelve Months), calculated using the latest four quarterly financial reports.

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

Suppose TSMC announced an EPS of 5 yuan in Q1 2023; then, the total for the latest 4 quarters becomes: Q2 2022 (9.14) + Q3 (10.83) + Q4 (11.41) + Q1 2023 (5) = 36.38 yuan. At this point, PE(TTM) = 520 ÷ 36.38 = 14.3 times.

Compared to the static P/E ratio, the rolling P/E ratio better reflects the company’s current profitability but still cannot predict the future.

Dynamic P/E Ratio: Pricing Based on Future Expectations

Calculation formula: PE = Stock Price ÷ Estimated Annual EPS

The estimated P/E uses forecasts of future EPS from analysts or institutions. For example, if the estimated EPS for TSMC in 2023 is 35 yuan, then dynamic PE = 520 ÷ 35 = 14.9 times.

This indicator’s benefit is that it reflects the market’s expectations for the company’s prospects, but because it involves forecasts, its accuracy is often uncertain. Different institutions’ estimates can vary greatly, which may cause confusion in investment judgments.

Industry Comparison Method: Finding Reasonable Valuation Levels

To determine whether a company’s P/E ratio is reasonable, the most direct approach is horizontal comparison—benchmarking against similar companies within the same industry or business type.

According to data from Taiwan Stock Exchange’s industry classifications, the average P/E ratios vary greatly across sectors. For example, the automotive industry might have an average P/E of up to 98, while the shipping industry might only be 1.8. Clearly, these companies cannot be directly compared.

Taking TSMC as an example, it should be compared with other wafer foundries like UMC and Powertech. Currently, TSMC’s P/E ratio is about 23.85, while UMC is around 15. Relative to UMC, TSMC’s valuation is indeed higher—but this may reflect its technological leadership and market position premium.

P/E River Chart: Visualizing Stock Price Highs and Lows

Investors wanting a quick judgment on whether a stock is overvalued or undervalued can use a P/E river chart.

This chart typically shows 5-6 parallel lines over the stock price trend, with each line calculated as: Stock Price = EPS × P/E multiple. The top line represents the highest historical P/E corresponding stock price, and the bottom line the lowest.

For example, if TSMC’s current stock price is between the 13x P/E line and the 14.8x P/E line, and it is in the lower half of the river chart, it indicates the stock may be undervalued and could be a good buying point. However, this is only a valuation signal and does not guarantee profits after purchase, as many factors influence stock prices.

Three Major Limitations of the P/E Ratio

Although the P/E ratio is the most commonly used valuation tool, it is not perfect:

First, it ignores corporate debt. The P/E ratio only considers net profit, neglecting the company’s debt situation. Two companies with the same P/E may have vastly different risks and safety margins if one has high debt and the other has little. During economic downturns or rising interest rates, highly leveraged companies face greater risks.

Second, it is difficult to precisely define high or low. A high P/E may indicate short-term difficulties but strong fundamentals, or it could reflect market optimism about future growth, or even a bubble. Relying solely on historical experience can lead to errors.

Third, it cannot evaluate unprofitable companies. Startups, biotech firms, and many other companies that have not yet achieved profitability cannot be evaluated using the P/E ratio. In such cases, other indicators like Price-to-Book (PB) or Price-to-Sales (PS) ratios are needed.

Application Scenarios for PE, PB, and PS Valuation Indicators

Different types of companies should use different valuation metrics:

P/E Ratio (PE): Best suited for mature, profitable companies with stable earnings. Calculated as stock price divided by EPS; a higher PE indicates a more expensive stock. This indicator is most relevant for blue-chip stocks and traditional industries.

Price-to-Book Ratio (PB): Suitable for cyclical and asset-intensive industries. Calculated as stock price divided by net asset value per share. When PB is less than 1, the stock is considered undervalued; above 1, overvalued.

Price-to-Sales Ratio (PS): Used for evaluating growth companies that are not yet profitable. Calculated as stock price divided by revenue per share; a higher PS indicates a more expensive stock, more relevant for emerging tech companies.

Investment Advice: The P/E Ratio Is Just the Beginning

Mastering the calculation and application of the P/E ratio is only the first step in stock investing. A high P/E does not necessarily mean the stock price will fall, nor does a low P/E guarantee it will rise—many tech stocks, despite high valuations, continue to rise because the market is optimistic about their growth prospects.

Investment decisions should be multi-dimensional, incorporating a company’s competitiveness, industry outlook, financial health, macroeconomic environment, and more. The P/E ratio is merely a tool to help us form an initial understanding, not the sole determinant.

Using the P/E ratio rationally while being aware of its limitations is the attitude of a mature investor.