The relationship between PE and EPS: Understanding the essence and application of the Price-to-Earnings ratio in one article

When it comes to stock valuation, the Price-to-Earnings ratio (PE) is undoubtedly one of the most frequently referenced indicators. Many seasoned investors and analysts often discuss a company’s historical PE levels to infer whether the current price is reasonable. So, what secrets does this seemingly simple yet actually complex metric hide? This article will start from the relationship between EPS and PE to reveal the underlying principles.

Definition of PE: Understanding Price Through Time

The PE ratio, also known as the Price-to-Earnings ratio or PER (Price-to-Earning Ratio), fundamentally reflects how many years of earnings are needed to recover the current stock price. In other words, it indicates how the market prices a company’s current profitability.

For example, if a tech company’s PE is 20, it means that at the current earnings rate, it would take 20 years to earn back the current market value. This is why PE is often used to assess whether a stock is relatively overvalued or undervalued.

How EPS Drives the Calculation of PE

The calculation of PE relies on Earnings Per Share (EPS), and their relationship can be simplified as: PE = Share Price ÷ EPS

This formula shows that, with the same share price, higher EPS results in a lower PE; conversely, lower EPS results in a higher PE. The relationship is inverse.

Taking a well-known chip manufacturer as an example, suppose the current share price is 520 yuan, and the EPS for 2022 is 39.2 yuan. Then, PE = 520 ÷ 39.2 ≈ 13.3 times. This number reflects that the market expects the company to take about 13 years to recover its current investment cost through profits.

Three Dimensions of PE Calculation

Depending on the source of EPS, PE can be categorized into three main types:

Static Price-to-Earnings Ratio (Historical PE) Calculation formula: PE = Share Price ÷ Annual EPS. The annual EPS usually comes from the previous year’s financial report or the sum of the EPS over the past four quarters. Since the annual EPS remains unchanged before the new financial report is released, the only driver of PE fluctuations is stock price movement, hence the name “static.”

For example, for a chip manufacturer, annual EPS can be expressed as: Q1 EPS + Q2 EPS + Q3 EPS + Q4 EPS = 7.82 + 9.14 + 10.83 + 11.41 = 39.2 yuan.

Rolling PE (Historical PE) Also called TTM (Trailing Twelve Months), it uses the latest four quarters’ EPS sum for calculation: PE (TTM) = Share Price ÷ Sum of EPS over the latest 4 quarters.

This method’s advantage is that each time a new quarterly report is released, the PE data updates in real-time, avoiding the lag of static PE. For example, if the new quarter EPS is 5 yuan, then the latest four quarters’ EPS = 9.14 + 10.83 + 11.41 + 5 = 36.38 yuan, and PE (TTM) = 520 ÷ 36.38 ≈ 14.3 times. Meanwhile, the static PE remains at 13.3 times, but the rolling PE has increased to 14.3 times.

Dynamic PE (Estimated PE) Based on forecasts by institutions or analysts for future EPS, the formula is: PE = Share Price ÷ Estimated Annual EPS. If an institution estimates the company’s 2024 EPS to be 35 yuan, then the dynamic PE = 520 ÷ 35 ≈ 14.9 times.

It is important to note that due to differing forecasts among institutions and potential overestimation or underestimation by the company itself, this indicator’s practical utility is relatively limited.

How to Judge High or Low PE

Simply looking at the PE value is meaningless; it requires comparison through two main methods:

Industry Benchmarking Different industries have vastly different average PE levels. For example, data from a certain exchange in 2023 shows that the average PE in the automotive industry might reach as high as 98, while the shipping industry might only be 1.8. Therefore, comparisons are only meaningful among companies within the same industry and similar business models.

For instance, among chip manufacturers, compare PE ratios: if the company’s PE is 13, and its competitors A and B are 8 and 47 respectively, then this company’s PE is in the middle range and not considered significantly overvalued.

Historical Longitudinal Comparison Compare the company’s current PE with its historical PE trend over several years to assess its valuation position. If the current PE is below the 90th percentile of the past five years, it indicates the company is relatively cheap; if above, it might be overvalued.

Such comparative analysis helps us evaluate whether a company presents an investment opportunity more objectively.

Practical Application of the PE River Chart

The PE river chart is an intuitive valuation tool that displays different PE multiples as a river, helping investors quickly identify the valuation zone of the current stock price.

The principle is: Stock Price = EPS × PE. The top of the river represents the highest historical PE-based stock price, the bottom the lowest, and the middle zones are transitional bands for various multiples.

When the stock price is in the lower half of the river, it generally suggests undervaluation and potential for growth; when it reaches the upper half or even surpasses the top, caution about overvaluation is warranted.

It is important to emphasize that the PE river chart is only a reference tool. It cannot guarantee profits from buying in the undervalued zone, as many factors influence stock prices beyond valuation alone.

Three Major Limitations of PE

Ignoring Debt Structure PE reflects only equity value and does not consider a company’s debt situation. A low-debt company and a high-debt company with the same PE carry vastly different risks. The former has better asset quality, while the latter faces greater pressure during economic downturns or rising interest rates.

Difficulty in Defining High or Low Precisely A high PE may result from short-term operational difficulties causing EPS to decline, while the company’s fundamentals remain strong; or it could be market anticipation of future growth, making next year’s PE look more reasonable; or it might be an overhyped stock needing correction. In these cases, relying solely on historical averages is challenging.

Inability to Assess Loss-Making Companies Emerging industries, biotech firms, and other companies not yet profitable cannot be evaluated using PE. Instead, metrics like Price-to-Book (PB) or Price-to-Sales (PS) are used as alternatives.

Comparison of PE, PB, and PS Usage Scenarios

Mastering the relationship between EPS and PE helps investors evaluate stock value more scientifically. The key is to understand that PE is just one of many valuation tools; it should be combined with company fundamentals, industry outlook, financial health, and other multidimensional information for comprehensive investment decisions.