PE is a valuation tool that investors need to know

When the prices of various stocks fluctuate in the market, a common question that investors often have is “Is the current price at a reasonable level for actual investment?” To answer such questions, one highly popular and continuously discussed investment formula among value investors (Value Investor) is PE or PE Ratio, which is a measure that helps us see a clearer picture of whether the stock price is appropriate.

What does PE mean?

PE is a ratio that shows the relationship between the stock price and the company’s earnings per share, or in other words, it indicates “if you buy this stock at the current price, how many years you need to wait to recover your initial investment based on the current earnings,” assuming the company’s profit remains the same every year.

The full name of PE is Price per Earning Ratio, commonly abbreviated as PE Ratio in the investment community.

How to calculate PE and related variables

The basic formula for PE is: PE = Stock Price ÷ EPS (Earnings Per Share)

This formula has two main components to understand:

Stock Price (Price) is the amount an investor pays to acquire one unit of stock. If you buy at a lower price, the resulting PE tends to be lower, which means investors can recover their investment faster.

EPS or Earning Per Share (Net profit per share) is calculated by dividing the company’s total net profit for the year by the total number of shares outstanding, giving a profit figure per share. A high EPS indicates efficient profit generation. Therefore, even if investors pay a higher price, they might still get a low PE because the denominator in the formula is high.

Basic principle: The lower the PE, the more reasonable the stock price, and the shorter the time needed to recover the investment, allowing investors to start making profits sooner.

Example Calculation

Suppose an investor buys a stock at 5 baht, and at the same time, the stock has an EPS of 0.5 baht. The PE calculation results in 10 times (5 ÷ 0.5 = 10).

A PE of 10 means the company pays a return of 0.5 baht annually to shareholders. Over 10 years, the total return would equal 5 baht, which is the initial investment amount. This means that at the end of year 10, the investor breaks even, and from year 11 onward, all received money is profit.

Forward PE and Trailing PE: Key Differences

Investors need to understand that PE can be calculated in two ways, depending on whether we use past profit data or future projections.

Forward PE (Forward PE) uses the current stock price divided by the projected future earnings. Its advantage is that it helps investors see the company’s outlook without being affected by other accounting changes. However, Forward PE has limitations because profit forecasts by the company and external analysts may differ, leading to confusion. Additionally, some companies may set overly conservative forecasts to make actual results appear better than expected.

Trailing PE (Trailing PE) uses the current stock price divided by the earnings per share over the past 12 months. This is the most popular method because the data is based on actual historical results and can be calculated quickly. Many investors prefer Trailing PE because it does not rely on forecasts from others.

The downside of Trailing PE is that past performance does not necessarily indicate future performance. If significant changes occur in the company’s situation, Trailing PE may be slow to reflect those changes.

Limitations of using PE to evaluate stocks

Although PE is a useful tool, it has some drawbacks that investors should be aware of.

The first issue is that EPS is not constant over time. If a company grows, EPS will increase, causing PE to decrease. For example, an investor buys a stock at 5 baht with an EPS of 0.5 baht (PE = 10). But after some time, the company expands production and exports, increasing EPS to 1 baht. The PE for the same stock would then drop to 5 times (5 ÷ 1 = 5). This means the investor would only need 5 years to recover the investment, not 10.

Conversely, if the company faces profit issues, such as trade restrictions or damages from special events, causing EPS to fall to 0.25 baht, the PE would rise to 20 times (5 ÷ 0.25 = 20). In this case, the investor would need to wait 20 years to recover the investment.

PE is a main tool but not the only one

When selecting stocks to add to an investor’s portfolio, relying solely on PE is not advisable. During volatile market periods, technical analysis tools can assist. However, when a good value investment opportunity appears and identifies undervalued stocks, it should not be overlooked.

PE is an effective tool because it allows investors to compare the relative valuation of different stocks in the market using a common standard. After screening stocks with PE, investors should analyze its limitations further to reduce investment risks.

By understanding PE what it is, how to calculate it, the differences between Forward PE and Trailing PE, and its limitations, investors will have comprehensive tools to make reasonable investment decisions and time their entry points at appropriate prices, aligning with their investment goals in a successful stock market journey.