Understanding what PE is in one article: a must-have course from beginner to valuation expert

Investing in stocks, the biggest fear is not knowing whether a company is worth buying. And PE (Price-to-Earnings Ratio / Market Price-Earnings Ratio) is the key indicator to help you make that judgment.

Many investors see analysts mention a company's PE and current stock price and feel confused. Today, we will break down this seemingly complex concept of PE, so you can truly understand the logic behind it.

What exactly is PE? Explained in one sentence

PE stands for Price-to-Earning Ratio (本益比/市盈率), simply put: how many years it takes for the company's profits to recover your initial investment.

For example, TSMC's current PE is around 23.85, meaning that assuming the company's annual profit remains unchanged, it would take 23.85 years to earn back your investment through the company's earnings. Conversely, this implies the company can provide you with an approximate 4.2% return annually.

Lower PE = Cheaper stock price (theoretically, faster to recoup investment)
Higher PE = Market has higher confidence in the company (possibly due to strong growth potential)

How to calculate PE? Two methods to look at

Method 1: Stock Price ÷ Earnings Per Share (EPS)

This is the most common calculation.

Formula: PE = Stock Price ÷ EPS

For example, TSMC:

• Current stock price: about NT$520
• 2022 EPS: NT$39.2
• PE = 520 ÷ 39.2 = 13.3 times

Method 2: Company Market Cap ÷ Net Profit

This method is suitable for directly assessing the company's valuation; the principle is the same.

Formula: PE = Market Cap ÷ Net Profit

The result aligns with Method 1, just scaled differently.

Types of PE? Static, Rolling, Estimated—you need to know

Depending on the earnings data used, PE can be divided into three categories:

Static PE: Uses EPS from the past full year

Formula: Stock Price ÷ Last year's EPS

For TSMC, 2022 EPS = 7.82 + 9.14 + 10.83 + 11.41 = 39.2

Features:

• Data is certain and fixed
• Reflects past performance, not timely
• When stock price changes, PE changes; EPS remains the same

( Rolling PE (TTM): Uses the most recent 12 months' EPS

Formula: Stock Price ÷ Sum of EPS over the last 4 quarters

This metric overcomes the lag issue of static PE. For example, if it's 2025 now, and we take Q2 22 + Q3 22 + Q4 22 + Q1 23 EPS, it better reflects current profitability.

Example: Suppose TSMC announces Q1 23 EPS as NT$5, then:

• Last 4 quarters EPS = 9.14 + 10.83 + 11.41 + 5 = 36.38
• Rolling PE = 520 ÷ 36.38 = 14.3 times

) Estimated PE: Uses analyst forecasts of EPS

Formula: Stock Price ÷ Estimated annual EPS

For instance, if institutions forecast TSMC's 2023 EPS at NT$35, then estimated PE = 520 ÷ 35 = 14.9 times

Features:

• Reflects future growth potential
• Accuracy is hard to guarantee (different analysts' estimates vary greatly)
• Companies often overstate or understate earnings

What PE is considered reasonable? Two methods to judge

( Method 1: Compare with industry peers

PE varies greatly across industries. Data from Taiwan Stock Exchange in February 2023 shows:

• Automotive industry PE: 98.3 (high growth)
• Shipping industry PE: 1.8 (traditional industries)

Compare within the same industry:

• TSMC PE: 23.85
• UMC PE: 15
• Compared to the market, TSMC is valued higher (due to its leading position)

) Method 2: Compare with the company's historical PE

Check whether the current PE is at a high, median, or low level historically.

TSMC's current PE is 23.85, which is in the upper-middle range of its five-year history—not at bubble highs but clearly above recession lows, indicating market optimism about its future.

PE River Chart: Visualize if a stock is expensive or cheap

There is a tool called the PE River Chart, which allows you to see at a glance whether a stock is overvalued or undervalued.

The principle is simple: Stock Price = EPS × PE multiple

The river chart typically shows 5-6 lines:

• Top line = stock price based on the highest historical PE
• Bottom line = stock price based on the lowest historical PE
• Middle lines = stock prices at different PE multiples

Looking at TSMC's river chart, if the current stock price is in the lower half, it suggests undervaluation and a potential buying point; if in the upper half, it may have already risen quite a bit.

Key point: Low PE doesn't necessarily mean profitable; high PE doesn't necessarily mean loss. The market is willing to assign high PE because it is optimistic about the company's prospects (many tech stocks have high PE and keep rising).

The three major limitations of PE, you must know

( Limitation 1: Ignores company debt

PE only considers equity value, ignoring corporate debt. Company A earning profits with own funds and Company B earning profits with borrowed funds look the same in PE, but the risks are entirely different. When interest rates rise or the economy downturns, Company B faces greater pressure.

) Limitation 2: Hard to judge absolute high or low PE

A high PE isn't always a bubble; it could be a company with temporary profit decline but stable outlook, or the market may be pricing in future growth early. Judging requires considering specific industry and company circumstances.

( Limitation 3: Cannot evaluate companies without profits

Startups, biotech, and other unprofitable companies cannot be valued using PE. In such cases, other metrics like PB (Price-to-Book ratio) or PS (Price-to-Sales ratio) are needed.

PE vs PB vs PS: The differences among three indicators

| Indicator | Chinese Name | Calculation Formula | How to interpret | Suitable for | |------------|----------------|---------------------|------------------|--------------| | PE | Price-to-Earnings Ratio | Stock Price ÷ EPS | Lower is cheaper | Mature companies with stable profits | | PB | Price-to-Book Ratio | Stock Price ÷ Net Asset per Share | PB<1 is relatively cheap | Cyclical, asset-heavy companies | | PS | Price-to-Sales Ratio | Stock Price ÷ Revenue per Share | Lower is cheaper | Unprofitable or loss-making new companies |

How to use PE for investment decisions?

1. Screen: Choose companies within the same industry with relatively low PE
2. Compare: Use PE river chart to assess current stock price position
3. Validate: Combine with company fundamentals, industry outlook, financial health for comprehensive judgment
4. Monitor: Regularly observe PE changes and understand the reasons (stock price movement or EPS change)

Remember, PE is just a reference; many factors influence stock price movements. Buying solely because PE is low or selling because PE is high can lead to pitfalls. The most important thing is to understand the logic behind PE and combine it with other analysis tools for decision-making.