Stock Valuation Essential: Price-to-Earnings Ratio (PE): Learning Financial Metrics in English from Zero

When it comes to stock investing, the Price-to-Earnings ratio (PE) is absolutely the core valuation tool you must master. Whether you’re a beginner or a seasoned investor, you’ll use the PE ratio to determine if a stock is cheap or expensive. But what exactly does the PE ratio measure? How is it expressed in English? This article will guide you through all aspects of this financial indicator.

What is the PE ratio? A simple understanding of the core concept of PE

The PE ratio is expressed in English as PE or PER, full name Price-to-Earning Ratio, also called Price-to-Earnings ratio in Chinese. Its core meaning is straightforward: divide the current stock price by the company’s annual earnings (earnings per share), and the resulting number indicates how many years it would take to recover your investment through the company’s profits.

From another perspective, a lower PE ratio indicates a relatively cheaper stock; a higher PE suggests the market has more optimistic expectations for the company’s future prospects and is willing to pay a premium. For example, TSMC’s PE has hovered around 13, meaning it would take about 13 years of earnings at that time to recoup the investment.

How to calculate the PE ratio? Two detailed formulas

There are two ways to calculate the PE ratio, with the first being the most commonly used in practice:

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

Method 2: Total Market Capitalization ÷ Net Profit = PE ratio

Practical example: Suppose TSMC’s stock price is NT$520, and its EPS in 2022 was NT$39.2, then PE = 520 ÷ 39.2 = 13.3. This means the stock price is approximately 13.3 times the annual earnings.

After understanding the English definition of Price-to-Earning Ratio, you’ll realize that the PE ratio is simply the ratio of stock price to earnings, with smaller numbers indicating a lower cost basis.

What types of PE ratios are there? Static, rolling, and dynamic categories

Based on the timing of the earnings data used, PE ratios can be divided into three main types, each suitable for different scenarios:

Static PE Ratio: Based on past year’s earnings

Calculation formula: PE = Stock Price ÷ Annual EPS

Annual EPS is the data published in the company’s annual report, or you can sum up quarterly EPS. For example, TSMC’s 2022 EPS equals Q1(7.82) + Q2(9.14) + Q3(10.83) + Q4(11.41) = 39.2.

The static PE ratio is relatively stable because the annual EPS doesn’t change before the new report is released. The PE fluctuations mainly come from stock price changes. This method is somewhat lagging and cannot reflect the latest operational conditions in real-time.

Rolling PE Ratio (TTM): Tracks the most recent 12 months’ PE

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

TTM stands for Trailing Twelve Months, meaning it uses the latest 12 months’ earnings for calculation. Since listed companies release quarterly reports, it actually sums the latest four quarters’ EPS.

Example: If TSMC reports Q1 2023 EPS of NT$5, then the sum of the latest 4 quarters’ EPS is 9.14 + 10.83 + 11.41 + 5 = NT$36.38, and the new rolling PE is 520 ÷ 36.38 ≈ 14.3. This shows that the rolling PE can more timely reflect the company’s latest operational performance compared to the static PE.

Dynamic PE Ratio: Based on estimated future earnings

Calculation formula: PE = Stock Price ÷ Estimated Annual EPS

Dynamic PE uses projected future earnings. For example, if analysts estimate TSMC’s 2023 EPS to be NT$35, then dynamic PE = 520 ÷ 35 ≈ 14.9.

Note that estimates from different institutions can vary greatly, and company projections may be overly optimistic or conservative. Therefore, the accuracy of dynamic PE is often less than the first two types, but it has the advantage of reflecting growth potential.

What is a reasonable PE ratio? Two approaches to judge high or low valuation

When you see a PE number, how can you tell if it’s high or low? The most practical method is comparative analysis:

Method 1: Cross-industry comparison

PE ratios vary greatly across industries. According to Taiwan Stock Exchange data, the PE for the automotive industry can reach 98.3, while shipping industry PE is only 1.8. Clearly, these cannot be directly compared.

When comparing, choose companies within the same industry and similar business types. For example, compare TSMC with UMC and Powerchip, all wafer foundries. If TSMC’s PE is 23.85 and UMC’s is 15, TSMC’s valuation is relatively higher.

Method 2: Longitudinal comparison within the same company

Compare the current PE of a company with its historical data over 5 or 10 years to assess its valuation position.

For example, if TSMC’s current PE is 23.85, and this falls in the upper-middle range of its 5-year history, neither at bubble highs nor at recession lows, it indicates the market expects a healthy recovery after improvement.

PE River Chart: Visual tool to intuitively judge stock price high or low

To quickly determine whether a stock is overvalued or undervalued, the PE River Chart is the most intuitive tool.

The river chart typically consists of 5 to 6 lines, based on the principle: Stock Price = EPS × PE. The top line uses the historical highest PE, the bottom line uses the historical lowest PE, and the middle lines represent average or median PE.

When the stock price is below the river chart, it indicates undervaluation and is often a good buying opportunity; if above, it suggests overvaluation. For example, if TSMC’s stock price is between 13x PE and 14.8x PE and located in the lower region, it is relatively cheap.

A special reminder: A low PE does not necessarily mean the stock price will rise; a high PE does not guarantee a decline. The market’s willingness to assign high valuations to certain stocks often reflects confidence in their future growth. Many tech stocks have high PE ratios but continue to rise, which is the reason.

The three main limitations and cautions when using the PE ratio

Although the PE ratio is the most commonly used valuation metric, it has notable limitations:

Limitation 1: Ignores the impact of corporate debt

The PE ratio considers only equity value and completely ignores a company’s debt situation. Two companies with the same PE can have vastly different risk profiles if one has high debt and the other has little.

For example, in the same industry, Company A profits from its own assets, while Company B relies on borrowing. When economic conditions change or interest rates rise, B faces higher risks. Even if EPS is similar, A’s stock price is usually higher due to a higher safety margin, so B isn’t necessarily cheap—A simply has a higher safety buffer.

Limitation 2: Difficult to define what constitutes a high or low PE

A high PE can result from various reasons: short-term poor performance with strong fundamentals, market anticipation of future growth, or overhyped stocks needing correction. Each scenario carries different investment implications, making it hard to judge solely based on historical PE levels.

Limitation 3: Cannot evaluate companies without profits

Many startups or biotech firms are not profitable yet, so their PE cannot be calculated. In such cases, investors need to use other valuation metrics.

The differences and applications of PE, PB, and PS valuation metrics

Besides PE, there are two other important financial ratios: Price-to-Book (PB) and Price-to-Sales (PS), used in different valuation scenarios:

Mastering PE and its English term Price-to-Earning Ratio, along with PB and PS, will allow you to evaluate a stock’s valuation more comprehensively and find targets aligned with your investment strategy. Remember, PE is just a reference; sound investment decisions should also consider company fundamentals, industry outlook, and market environment from multiple dimensions.