How to use PE to select undervalued stocks

When the stock market experiences a sharp decline, many investors face a difficult question - are the current stock prices truly worth it? Should they buy now? And if they do, how long will it take to see a profit?

Deciding on stock prices depends on many factors, but if you want a systematic and widely accepted method in the investment community, value investors often refer to a fundamental indicator called the PE ratio, which is a powerful tool for measuring whether a stock is overvalued or undervalued.

PE Ratio - The metric indicating the payback period

PE ratio or Price per Earning ratio compares the price you pay for a stock with the company’s earnings. This metric tells you how many years it would take to recover your investment if the company’s profit remains the same.

For example, if you buy a stock at 5 baht and the earnings per share (EPS) is (EPS) 0.5 baht, then the PE ratio is 10 times. This means that in 10 years, the accumulated profit will equal the initial purchase price.

How to calculate the PE Ratio

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

The first factor is stock price. The lower the purchase price, the lower the PE ratio, which indicates a shorter payback period.

The second factor is EPS or Earnings Per Share. This is the net profit shared per share. If a company has a high EPS, even if the stock price is relatively high, the PE may still be low because the company has strong profit-generating ability.

In short: Low PE = Cheap stock = Fast payback = Good buy signal

Forward PE vs Trailing PE - Which one to choose

Investors encounter two types of PE ratios depending on the data used:

Forward PE - Looking ahead

Forward PE compares the current stock price with projected future earnings. This approach helps visualize the company’s future prospects. However, Forward PE has drawbacks due to estimation errors; companies may underestimate profits to make future results look better, or external analysts may provide different figures from the company’s own estimates.

Trailing PE - Based on historical data

Trailing PE uses earnings data from the past 12 months. This is the most popular method because it relies on concrete, finalized data without depending on estimates from others.

The limitation of Trailing PE is that it only reflects past performance. If a company recently faced a crisis, the PE may not reflect the upcoming recovery.

Limitations investors should be aware of

While PE is a useful tool, it doesn’t tell the whole story about a stock.

First, EPS is not constant. When a company expands production, enters new markets, or achieves new successes, EPS can increase suddenly, causing the PE to decrease. For example, if our example company grows and EPS rises to 1 baht, the PE drops to 5 times, meaning you can recover your investment in just 5 years instead of 10.

Second, negative factors can damage EPS. If the company faces major challenges such as disputes, trade issues, or legal liabilities, EPS may decline. If EPS drops to 0.25 baht, the PE jumps to 20 times, meaning you would need 20 years to recover your investment.

How to use PE effectively

Despite its limitations, PE remains a standard tool for comparing stock valuations in the market. A good approach is:

1. Use PE as a first filter to identify stocks with reasonable prices (PE low)
2. Conduct deeper analysis by examining the company’s fundamentals, future EPS trends, and business environment
3. Recheck limitations before making an investment decision to avoid mistakes

Summary

Successful investors do not rely on a single tool, but PE ratio is a fundamental metric everyone should understand. By learning how to use PE to evaluate stock prices, you’ll have essential information to make better investment decisions. PE is another tool that should be in every investor’s toolkit, helping you time the market and invest in good stocks with greater confidence.