Cracking the Price-to-Earnings Ratio Investment Puzzle: A Complete Guide from 0 to 1

When investing in stocks, the biggest risk isn’t market fluctuations, but buying at a high price without realizing it. That’s why investment advisors often mention “what is the current Price-to-Earnings Ratio (PE or PER)”—because PE is almost the most direct indicator to measure whether a stock is expensive or cheap. Today, we’ll thoroughly break down this seemingly complex but actually very practical tool.

What exactly does the PE ratio measure?

First, it’s important to understand a core concept: PE ratio (Price-to-Earnings Ratio, full name Price-to-Earning Ratio) essentially tells you how many years it takes to recoup your investment.

Here’s an intuitive example. TSMC’s current PE is around 13, which means: if you buy TSMC stock now, based on the company’s current profitability, it would take 13 years to earn back your initial investment. In other words, the company needs 13 years to generate enough profit to match its current market value.

This is also why stocks with high PE ratios are generally considered “expensive,” and those with low PE ratios are considered “cheap”—this is the fundamental logic for assessing stock valuation reasonableness.

How to calculate PE? It’s actually very simple

The calculation formula is just one: Stock Price ÷ Earnings Per Share (EPS) = PE ratio

Using TSMC as an example: current stock price is 520 NT dollars, and the EPS for 2022 is 39.2 NT dollars, so PE = 520 ÷ 39.2 = 13.3.

Another method is to divide the company’s total market capitalization by the net profit attributable to common shareholders; the result is the same. But in daily investing, we mainly use the first method.

Some may ask, why not compare directly using the stock price? Because companies differ in size and share capital, and stock price alone isn’t comparable. Using PE solves this problem—it is a “standardized” valuation metric.

There are three types of PE ratios; choosing the right one is crucial

There are three types of PE ratios circulating in the market, with the main difference being the EPS data used:

Static PE (Historical PE)

This is the most common type, calculated using annual EPS. The formula is: Stock Price ÷ Annual EPS. The annual EPS is usually confirmed when the company releases its annual financial report, and then it remains unchanged—unless the stock price moves, PE won’t change either, hence called “static.”

For example: TSMC’s 2022 EPS is the sum of four quarters (7.82+9.14+10.83+11.41=39.2). Using the current stock price of 520 NT dollars divided by this annual EPS gives the static PE.

Rolling PE (TTM, latest 4 quarters EPS)

This method uses the latest 12 months’ EPS, since listed companies report quarterly, which effectively sums the latest four quarters’ EPS. The formula is: Stock Price ÷ Sum of latest 4 quarters EPS.

Suppose TSMC’s Q1 2023 EPS is 5; then the latest 4 quarters’ EPS sum to (9.14+10.83+11.41+5=36.38), and the new rolling PE = 520 ÷ 36.38 ≈ 14.3.

Compared to static PE of 13.3, the rolling PE updates more frequently. This metric overcomes the lag of static PE but still reflects past data and cannot predict future performance.

Forward PE (Estimated PE)

This uses projected future EPS. The formula is: Stock Price ÷ Estimated annual EPS.

For example, if an institution estimates TSMC’s 2023 EPS to be 35, then Forward PE = 520 ÷ 35 ≈ 14.9.

In theory, this is the most forward-looking indicator, reflecting market expectations for the future. However, the problem is different institutions’ estimates vary, and companies may overstate or understate their earnings, making it less reliable in practice.

What PE ratio is considered reasonable? Benchmarking is key

When you see a PE number, how do you judge whether it’s high or low? There are two methods:

Compare with industry peers

PE ratios vary greatly across industries. For example, data from the Taiwan Stock Exchange in February 2023 shows that the automotive industry has a PE as high as 98.3, while the shipping industry is as low as 1.8. So, comparing PE across different industries makes no sense.

Take TSMC as an example: it should be compared with other semiconductor companies like UMC (PE of 8) or Powertech (PE of 47). TSMC’s PE of 13 is between these two, so relatively speaking, it’s not considered expensive.

Compare with the company’s own historical PE

Look at the current PE against its past PE levels. TSMC’s current PE of 13 is lower than 90% of its PE over the past five years, indicating the current valuation is relatively cheap.

This comparison method considers industry characteristics and avoids the problem of “comparing apples to oranges.”

Use the PE river chart to visually assess stock valuation

No matter how much theory you learn, a visual tool is more effective. The PE river chart is such a tool.

The principle is simple: Stock Price = EPS × PE. The river chart typically has 5 to 6 lines, with the top line representing the stock price based on the highest historical PE, and the bottom line based on the lowest historical PE. The middle lines correspond to different PE multiples.

Looking at TSMC’s river chart, the current stock price is between the purple line (13 PE) and the blue line (14.8 PE), indicating it is in a relatively undervalued zone. This is often considered a good entry point.

However, be cautious—seeing a stock as undervalued and rushing to buy is overly simplistic. Many factors influence stock prices, and a low PE is just a basic indicator, not a guarantee of profit.

PE ratio and stock price movement are not necessarily related

Many believe that low PE stocks will definitely rise, and high PE stocks will definitely fall—that’s a misconception.

Low PE stocks don’t necessarily go up, and high PE stocks don’t necessarily go down.

Why? Because investors are willing to assign high valuations to certain stocks because they are optimistic about the company’s future. Many tech stocks have high PE ratios but continue to perform well, which illustrates this point. PE reflects current market expectations, not certain future outcomes.

PE ratio has fatal flaws; investors should be cautious

Although PE is a useful tool, it has limitations:

Ignores debt impact

PE only considers equity value, ignoring a company’s debt. Two companies with the same PE may have vastly different risks—one with low debt, another with high debt. When the economy downturns or interest rates rise, high-debt companies are more exposed. Relying solely on PE often underestimates the risk of highly leveraged companies.

Difficult to accurately judge whether PE is high or low

A high PE might mean the company is temporarily undervalued but fundamentally sound, and investors are willing to hold; it could also mean expectations for future growth are high; or it might be just hype. These situations differ, and simple historical experience can’t always tell them apart.

Startups and unprofitable companies can’t use PE

Biotech firms and startups without profits can’t calculate PE. In such cases, other indicators like Price-to-Book (PB) or Price-to-Sales (PS) are used.

PE, PB, PS—each has its purpose

• PE (Price-to-Earnings Ratio): Stock Price ÷ EPS. Suitable for profitable, stable companies. Higher PE indicates more expensive stock.
• PB (Price-to-Book Ratio): Stock Price ÷ Book Value per Share. Suitable for cyclical companies. PB < 1 often indicates undervaluation.
• PS (Price-to-Sales Ratio): Stock Price ÷ Revenue per Share. Suitable for emerging companies not yet profitable. Higher PS suggests higher valuation.

Mastering PE is just the first step in investing. To achieve consistent profits, you need to combine multiple indicators, industry trends, and company fundamentals for comprehensive analysis. A cheap PE doesn’t necessarily mean you should buy, and a high PE doesn’t guarantee a decline—what matters is understanding the underlying logic and applying it flexibly according to your investment strategy.