P.E. means: A guide for stock investors who want to measure value accurately

When the stock market experiences a significant decline, many investors start looking for interesting stocks. But the key question is: Is the current price cheap or expensive? And when is the right time to buy? To find the answers, investors need tools that provide a clear picture, not just rely on intuition.

There are various ways to measure the value of a stock, but the most popular tool among (Value Investors) is the P.E. ratio or Price-to-Earnings ratio, which indicates the relationship between the stock price and earnings per share.

What is the P.E. ratio and what does it mean?

P.E. ratio (Price per Earning ratio) is a ratio that shows how many years it would take to recover the investment if you buy the stock at this price, based on the company’s annual profit.

This indicator is important because it allows investors to compare different stocks on a standard basis, rather than guessing without a foundation.

The P.E. ratio is divided into two types: Forward vs. Trailing

When using the P.E. ratio, it is categorized into two types with different characteristics and benefits:

Forward P/E (Forecast P/E) uses the current stock price divided by the projected future earnings. This approach is useful because it provides a view of the company’s future prospects. However, it has limitations, as some companies may underestimate future profits to appear more attractive, leading to a higher P.E. ratio once actual results are announced. Additionally, external analysts may provide different estimates, which can cause confusion for investors.

Trailing P/E (Historical P/E) uses the current stock price divided by earnings per share from the past twelve months. Since it relies on actual historical data, it is the most commonly used method. However, its downside is that past performance does not necessarily predict future performance. Therefore, investors should consider how much profit the company will generate in the future, not just look at past results.

How to calculate the P.E. Ratio

The calculation formula for the P.E. ratio is straightforward: P.E. = Stock Price ÷ EPS (Earnings Per Share)

This equation involves two main factors:

Stock Price (Price) is the amount investors pay to buy the stock. The lower the price, the lower the P.E., and the sooner the break-even point.

Earnings Per Share (EPS - Earnings Per Share) is obtained by dividing the company’s net profit by the total number of shares outstanding. This indicates how much profit each shareholder receives annually. A high EPS suggests strong profitability.

Example calculation: Suppose you buy a stock at 50 units, and the EPS is 5 units. The P.E. = 50 ÷ 5 = 10 times. This means investors need to wait 10 years to recover their initial investment (assuming the company maintains the same profit every year). After 10 years, investors will start receiving actual profits.

The limitations of the P.E. Ratio that investors should remember

Although the P.E. ratio is a useful tool, it has important limitations.

First, EPS is not constant over time. It can fluctuate based on the company’s performance. For example, if a company expands production or enters new high-potential markets, EPS may increase, leading to a lower P.E., indicating a quicker break-even point.

Conversely, if the company faces significant challenges, such as trade disruptions or increased expenses, EPS may decrease, resulting in a higher P.E., and investors will need to wait longer to reach the break-even point.

Second, the P.E. ratio does not reflect the quality of the company’s financial structure. A low P.E. might be due to high EPS resulting from efficient management, or it could be because the stock price has fallen due to other issues not reflected in the P.E. figure. Therefore, further analysis is necessary.

How to use the P.E. Ratio for investment decisions

After understanding what the P.E. ratio means and its limitations, the next step is to use it effectively.

Investors should use the P.E. ratio as an initial screening tool to identify stocks with reasonable prices. Then, conduct a deeper analysis of the company, including growth potential, financial health, and industry trends.

Comparing the P.E. ratios of stocks within the same industry is also a good approach, as it helps identify which stocks are more valuable.

Summary

Investors aiming to time their stock purchases accurately should not rely on a single tool. The P.E. ratio is part of a set of essential tools. When combined with other analyses, it can help investors make better investment decisions.

Understanding what the P.E. ratio is and how to use it correctly provides investors with sufficient information to build a strong stock portfolio. Continuous study and skill improvement in analysis are also crucial steps toward success in the stock market.