How to interpret the PER ratio: a practical guide for investors

The PER ratio represents one of the fundamental indicators in stock market analysis, although its correct interpretation requires much more than applying a mathematical formula. This article delves into how to properly evaluate this ratio, its limitations, and its strategic application in investment portfolios.

The true meaning of the PER ratio

When we talk about the PER ratio, we refer to the quotient between a stock’s market price and its periodic earnings. The initials stand for Price/Earnings Ratio.

Essentially, this indicator tells us how many years of current (projected over 12 months) earnings would be needed to recover the investment in a company. If a company has a PER of 15, it means that its annual earnings would pay off its total market capitalization in 15 years.

The PER ratio is part of the six crucial indicators to assess corporate health, along with EPS (earnings per share), P/BV (price to book value), EBITDA, ROE (return on equity), and ROA (return on assets).

Calculation formulas: two equivalent approaches

This ratio can be obtained through two methods that provide identical information:

Aggregate method: Total market capitalization ÷ Total net profit

Per share method: Share price ÷ Earnings per share (EPS)

Both formulas are accessible, as the required data are publicly available on any financial platform. The choice between one or the other depends solely on the information available at the time of analysis.

Where to find these data

On Spanish platforms like Infobolsa, the ratio is listed under the name “PER,” while on North American and British portals (Yahoo! Finance, Bloomberg) the term “P/E” prevails. Both designations are equivalent.

Alongside the PER ratio, platforms offer additional information: market capitalization, 52-week price range, number of shares outstanding, and other parameters necessary for comprehensive analysis.

Practical calculation examples

Case of analysis by absolute amounts: A company with a market cap of 2,600 million dollars and net earnings of 658 million dollars would have a PER of 3.95 (2,600 ÷ 658).

Case of analysis per share: An asset trading at $2.78 with EPS of $0.09 yields a PER of 30.9 (2.78 ÷ 0.09).

Differences in these figures illustrate how companies in the same sector can have radically different valuations.

Technical variants: Shiller PER and normalized PER

Shiller PER

This variant aims to correct the temporal limitation of the conventional PER. Instead of considering earnings from a single fiscal year, it incorporates the average of the last 10 years adjusted for inflation.

The premise is that a decade of data provides a more faithful picture of a company’s profit-generating capacity. According to this methodology, the earnings trends of the past 10 years allow projecting the next 20 years more accurately.

Although it has defenders among quantitative analysts, it also faces criticism questioning the validity of its statistical assumptions.

Normalized PER

This approach adjusts the formula to more accurately reflect the company’s true financial health:

Numerator: Market capitalization - Liquid assets + Financial debt

Denominator: Free Cash Flow (instead of net profit)

This calculation dissects “the grain from the chaff,” revealing the true cash generation capacity. An illustrative example was the acquisition of Banco Popular by Banco Santander, apparently for “1 euro,” when in reality it involved assuming massive debt that completely altered the valuation.

Interpretation of PER ranges depending on context

Conventional interpretation suggests standard ranges, though reality is more nuanced:

• PER between 0 and 10: Potentially attractive but requires in-depth research. Low values may indicate companies facing imminent decline.
• PER between 10 and 17: Considered optimal range by conservative analysts, suggesting moderate growth without overvaluation.
• PER between 17 and 25: Signal of recent growth or a possible speculative bubble forming.
• PER above 25: Dual interpretation: either very positive expectations or formation of a financial bubble.

The sector determines the correct reading

One of the biggest pitfalls in PER analysis is comparing companies from different industries. The structural characteristics of the sector have a decisive influence on this ratio’s values.

Sectors with historically low PERs: Banking, extractive industries, construction. ArcelorMittal (steel) trades with a PER close to 2.58.

Sectors with typically high PERs: Technology, biotechnology, software. Zoom Video maintains ratios above 200 points.

Assuming both valuations are directly comparable is a fundamental analytical error. A low PER in technology would indicate potential business crisis, while a PER of 25 in banking would suggest overvaluation.

PER behavior in market cycles

Stock market history shows that PER does not function as a mechanical indicator. Meta Platforms (Facebook) experienced price drops despite decreasing PERs during 2020-2022, due to changes in investors’ risk appetite amid interest rate hikes by monetary authorities.

Similarly, companies with stable PERs maintain stock volatility because the market constantly revises its expectations of future earnings beyond past numbers.

In cyclical companies, PER can be especially misleading: at the peak of the cycle, it shows low values (maximum profit reached), while during downturns, it shows high values (collapsed earnings).

Value Investing and its dependence on PER

Value Investing managers heavily use this ratio seeking “good companies at inappropriate prices.” Funds like Horos Value Internacional maintain a PER of 7.24 versus 14.55 in their category, or Cobas Internacional with 5.46, demonstrating a systematic strategy of undervaluation search.

However, this methodology requires additional sophistication: many undervalued (low PER) companies remain so because of poor management and are heading toward insolvency.

Critical limitations of the PER ratio

• Limited periodicity: Only considers earnings from one fiscal year for future projections, ignoring multi-cycle trends.
• Inapplicable to loss-making companies: Startups, companies in digital transformation, or with losses have undefined or negative PER.
• Static perspective: Reflects only a snapshot of corporate performance, not future market or management dynamics.
• Possible accounting tricks: Earnings can be inflated through one-off asset sales, not reflecting recurring operations.

Essential complementary tools

A robust analysis should never rely solely on PER. It must be combined with:

• EPS (Earnings Per Share): Checks earnings growth consistency.
• Price/Book Value: Compares market valuation versus net equity.
• ROE and ROA: Measure efficiency in generating profitability.
• RoTE (Return on Tangible Equity): Return on tangible equity.
• Cost structure analysis: Identifies whether profits come from core business or one-off events.

Operational summary

The PER ratio is an effective tool for quick sector comparisons but is only a component of comprehensive fundamental analysis. Its greatest utility lies in identifying candidates for in-depth investigation, never as the sole decision criterion.

Successful investors dedicate substantial time to analyzing operating margins, revenue trends, debt quality, and the company’s competitive position beyond what simple price-to-earnings division reveals. Combining PER with these fundamental factors builds the foundation for well-supported and profitable long-term investment decisions.