How to correctly evaluate whether a stock is overvalued or undervalued using the P/E Ratio

When the stock market experiences a sharp decline, many investors start looking for opportunities to accumulate undervalued stocks. But the burning questions are “Is the current price truly cheap?” and “When will I start to incur losses and begin to profit from holding stocks?” Among various methods to measure stock value, there is one tool that value investors favor the most: the PE ratio, which provides a clear picture of how reasonable each stock’s price is.

P/E is a ratio used to compare the price with the company’s earnings

P/E ratio or Price per Earning ratio accurately indicates the relationship between the stock price and earnings per share. This metric tells us how many years an investor must wait to recover their investment at the current price, assuming the company earns profits consistently every year.

The letter P stands for the price investors pay to buy the stock. The lower the price, the better, because it indicates a quicker return of investment. E or EPS (Earnings Per Share) is the net profit the company generates per share annually. This figure is obtained by dividing the company’s total profit by the total number of shares. Therefore, for each shareholder, EPS represents the “share of profit” they receive each year.

How to calculate the P/E Ratio is very simple: just divide the two numbers

The formula for calculating the P/E ratio is straightforward:

PE = Stock Price ÷ EPS

For example, to illustrate clearly, suppose an investor is interested in a stock priced at 5 baht per share, and the company’s EPS is 0.5 baht. Dividing 5 by 0.5 gives a P/E ratio of 10 times.

This number 10 means “waiting 10 years” at 0.5 baht per year, totaling 5 baht, which is the purchase price. After 10 years, the profit is fully recovered. The lower the P/E, the faster the loss is recovered, and the sooner the investor starts earning from holding the stock.

Forward P/E and Trailing P/E differ how

When analyzing the P/E ratio, investors will find two popular methods called Forward P/E and Trailing P/E.

Forward P/E uses future profit projections

Forward P/E divides the current stock price by the expected profit in the next year. It looks ahead. This metric is useful because it shows the company’s potential, but it also has drawbacks: forecasts are never 100% accurate. Sometimes, companies may underestimate profits to beat targets at the end of the period, or external analysts might provide figures that are far from reality.

Trailing P/E considers actual past performance

Trailing P/E looks back at the company’s earnings over the past 12 months. This method is popular because it uses real data, which can be calculated quickly. Many investors prefer Trailing P/E because it doesn’t rely on estimates from others. However, Trailing P/E has its weaknesses: past performance does not necessarily predict future results. If a company has recently experienced significant events, such as expanding production lines or entering new markets, Trailing P/E may not immediately reflect these changes.

P/E can change due to external factors, affecting the payback period

Although the P/E ratio is a valuable tool, investors should be aware of its limitations. The main issue is that EPS is not constant while holding the stock.

Imagine again: an investor buys a stock at 5 baht with an EPS of 0.5 baht, giving a P/E of 10 times, planning to wait 10 years. But after one year, the company expands significantly, increasing production and market share, causing EPS to rise to 1 baht. The P/E of this stock then becomes 5 times (5 ÷ 1), meaning the investment will be recovered in 5 years instead of 10.

Conversely, if the company faces problems, such as trade restrictions, and EPS drops to 0.25 baht, the P/E rises to 20 times (5 ÷ 0.25), implying a 20-year recovery period instead of 10. Changes in EPS make the payback time flexible and variable.

P/E Ratio remains an important indicator because it allows comparison between stocks

Despite its limitations, the P/E ratio remains the most popular standard for comparing stocks because it enables comparison across different stocks within the same market. Investors can use P/E to filter stocks initially, then conduct further analysis to understand its constraints. This approach helps reduce investment mistakes.

Summary: P/E is a powerful tool but should be used with other methods

Successful investors in the stock market do not rely solely on one tool. During volatile markets, technical analysis tools may be employed as well. But when the market is sluggish and opportunities to select good stocks arise, P/E ratio becomes a crucial weapon that helps pinpoint the right timing.

No matter how much a stock drops from its peak percentage, it may still be expensive, or a stock that has just fallen slightly might be overvalued. From what you’ve learned in this article, investors now understand what P/E is, how to use it, and what points to watch out for. P/E has become a tool that investors should keep in their arsenal to identify good opportunities and build their portfolios efficiently.