Stock Investment Must-Learn: How to Calculate Price-to-Earnings Ratio to Master Valuation Secrets

When investing in stocks, the Price-to-Earnings ratio (PE or PER) is a core tool for evaluating whether a company’s stock price is reasonable. Many professional investors use the PE ratio to measure a stock’s value and decide when to buy or sell. What exactly does the PE ratio do? How is it calculated? What do high or low values signify? This article will give you a comprehensive understanding of this essential investment indicator.

What Does the PE Ratio Measure

The PE ratio (also called Price-to-Earnings Ratio or PER), its core meaning is: how many years of a company’s net profit are needed to equal its current market capitalization. In other words, it shows how many years it would take to recover your initial investment through the company’s earnings if you buy the stock today.

For example, if TSMC’s PE ratio is 13, it means the company needs 13 years of profits to reach its current market value, implying that after purchasing TSMC stock, it would take about 13 years to fully recoup your investment. This indicator provides an intuitive reflection of the stock’s current valuation level.

How to Calculate the PE Ratio — Two Core Methods

There are mainly two ways to calculate the PE ratio: one is Stock Price ÷ Earnings Per Share (EPS), and the other is Market Capitalization ÷ Net Income attributable to common shareholders. In practice, the first method is most common.

Taking TSMC as an example: suppose the current stock price is 520 NT dollars, and the EPS for 2022 is 39.2 NT dollars, then PE = 520 ÷ 39.2 = 13.3. This is the current PE level of TSMC.

The calculation process seems simple, but the key lies in understanding the source of EPS. EPS from different periods can lead to variations in the PE ratio, which involves the next important concept.

Three Classifications of the PE Ratio

Depending on the time period of the EPS data used, the PE ratio can be divided into three main types, each with its own advantages and limitations.

Static Price-to-Earnings Ratio — Based on annual financial reports

Static PE formula: PE = Stock Price ÷ Annual EPS

Annual EPS is usually disclosed when the company releases its annual report, or by summing the EPS of the past four quarters. For TSMC, the 2022 EPS = Q1(7.82) + Q2(9.14) + Q3(10.83) + Q4(11.41) = 39.2 NT dollars.

This indicator’s characteristic is that the data is relatively stable, and before the new annual report is released, the value remains fixed. The PE fluctuation is entirely due to stock price changes. Therefore, it is called a “static” PE, but it also has a lag — it cannot reflect the latest operational conditions in real-time.

Rolling PE (TTM) — Tracks the latest four quarters’ PE

Rolling PE formula: PE (TTM) = Stock Price ÷ Sum of EPS over the latest 4 quarters

Since listed companies release quarterly financial reports, the rolling PE actually tracks the earnings over the most recent 12 months (4 quarters). Compared to static PE, it better reflects the company’s current operational performance.

For example, if Q1 2023 EPS is 5 NT dollars, then the latest four-quarter EPS = Q2(9.14) + Q3(10.83) + Q4(11.41) + Q1 2023(5) = 36.38 NT dollars, then the rolling PE = 520 ÷ 36.38 ≈ 14.3. Meanwhile, the static PE remains at 13.3, showing a difference.

Dynamic PE — Calculated based on forecasted earnings

Dynamic PE formula: PE = Stock Price ÷ Estimated Annual EPS

This method relies on institutional forecasts for the upcoming year’s earnings. For example, if an institution estimates TSMC’s 2023 EPS to be 35 NT dollars, then dynamic PE = 520 ÷ 35 ≈ 14.9.

The core issue with dynamic PE is the difficulty in accuracy, as different institutions’ forecasts vary greatly, and company projections can sometimes be overly optimistic or conservative, limiting the indicator’s practical use. However, its advantage is that it can preemptively reflect market expectations for future growth.

How to Interpret the PE Ratio to Judge if a Stock Price is Reasonable

After obtaining a stock’s PE ratio, how can you determine whether it is high or low? There are two main methods:

First, the Industry Comparison Method. Different industries have vastly different PE ratios — in 2023, Taiwanese automotive stocks have a PE as high as 98.3, while shipping industry stocks are only 1.8. This indicates huge industry differences. Therefore, comparisons should be made within the same industry, preferably among companies with similar business models.

For example, compare TSMC’s PE(13) with UMC(8) and Powertech(47). TSMC’s PE is in the middle range, and relatively not expensive.

Second, the Historical Comparison Method. Compare the current PE with the company’s PE trend over past years. If TSMC’s current PE is 13, and over the past 5 years, 90% of the trading time PE was higher than 13, then the current valuation is relatively cheap.

Viewing Stock Price Positioning via the PE River Chart

The PE river chart is an intuitive investment tool. It plots multiple lines representing the historical highest PE, lowest PE, median PE, etc., on the stock price chart, allowing investors to see at a glance where the stock’s valuation stands.

The principle is simple: Stock Price = EPS × PE. The top line represents the stock price corresponding to the historical highest PE, and the bottom line corresponds to the lowest PE.

If TSMC’s stock price is between these two lines, say in the middle-lower area (e.g., PE between 13 and 14.8), it indicates a relatively undervalued state, often seen as a buying opportunity. But it must be emphasized that undervalued stocks do not necessarily rise, as other factors like company fundamentals, industry outlook, and overall market environment must also be considered.

The Three Major Limitations of the PE Ratio You Must Know

Although the PE ratio is a commonly used valuation tool, it has obvious limitations:

First, it ignores corporate debt. The PE ratio only considers equity value and does not account for the company’s debt level. Two companies with the same PE, but one with low debt and the other highly leveraged, have completely different risks and values. Companies with low debt are generally safer; you cannot simply assume a high PE company is cheaper.

Second, it is difficult to define high or low precisely. A high PE might be due to temporary difficulties but strong fundamentals, with the market still willing to hold; or because of high future growth potential, with investors front-running; or it could be a bubble. The same PE level can have very different implications depending on context, making it hard to judge solely based on historical experience.

Third, it cannot evaluate unprofitable companies. Many startups or biotech firms have no profits, so PE cannot be calculated. In such cases, investors need to turn to alternative metrics like Price-to-Book (PB) or Price-to-Sales (PS).

The Strengths of PE, PB, and PS Indicators

Mastering how to calculate the PE ratio and understanding its application scenarios can help you evaluate stocks more rationally and avoid blindly chasing or selling in panic. However, investment decisions should be based on multiple indicators, fundamental analysis, and risk tolerance. Relying solely on one valuation tool is insufficient. Continuous learning and practice are the paths to becoming a better investor.