I have years of experience in the markets, and one thing that always comes back: people want to know if a stock is expensive or cheap. That’s what the P/E ratio is for, although most don’t really know what it means or how to interpret it. So I’m going to tell you what this P/E ratio is and why it should matter if you invest in the stock market.

Basically, the P/E ratio (Price/Earnings Ratio) is super simple: it divides the price of a stock by the company’s earnings per share over a year. That gives you the number of years it would take for current profits to pay for the total value of the company. If you see a company has a P/E of 15, it means that its 12-month earnings would need 15 years to equal its stock market value.

The interesting thing is that the P/E ratio is part of those 6 fundamental ratios that every serious investor should know: the P/E itself, EPS (earnings per share), P/BV (price-to-book value), EBITDA, ROE, and ROA. Along with EPS, the P/E is probably the indicator you can’t do without when selecting companies to invest in.

Now, calculating the P/E is a piece of cake. You have two ways: divide the market capitalization by the total net profit, or simply divide the stock price by EPS. Either way gives you the same result. The data is everywhere, so there’s no excuse not to do it yourself.

What I find interesting is how the P/E behaves in different situations. Look at Meta (Facebook): years ago, you saw the P/E decreasing while the stock kept rising steadily. That was a sign they were earning more and more money without the price increasing proportionally. But since late 2022, everything changed. The P/E kept falling, but the stock plummeted. Why? Because interest rates went up and the market stopped believing in the growth promises of tech companies.

With Boeing, it’s different. The P/E stays within a stable range, and the stock goes up and down accordingly. But what’s important here is the sign: sometimes the P/E is positive, sometimes negative. That says a lot about the company’s real health.

The interpretation of the P/E depends on the range you fall into. Between 0 and 10 is low, which can be attractive but also a sign that profits might fall. Between 10 and 17 is the zone most analysts like, because you expect growth without excessive risks. Between 17 and 25, you’re in territory of possible bubble or a company that has grown a lot. Above 25, well, anything can happen: either you’re looking at huge projections or a speculative bubble.

But here’s the important part: you can’t invest just by looking at the P/E. There are companies with low P/E that are about to go bankrupt because of disastrous management. The history is full of those cases. That’s why P/E should be combined with other ratios: ROE, ROA, Price/Book Value. And also, you need to understand the actual business behind the numbers.

What many don’t understand is that the P/E varies wildly depending on the sector. Banking and industrial companies tend to have low P/E ratios, while tech and biotech companies have very high P/E ratios. ArcelorMittal, which is in steel, has a P/E of 2.58. Zoom Video, which exploded during the pandemic, reached a P/E of 202. Comparing these two P/Es would be crazy.

There’s also the Shiller P/E, which some consider more realistic. Instead of taking only the profits of one year, it takes the average of the last 10 years adjusted for inflation. The idea is that this better captures reality, not just a potentially atypical year.

Then there’s the normalized P/E, which adjusts market capitalization by subtracting liquid assets and adding debt, and uses free cash flow instead of net profit. This is more accurate if you want to see what’s really happening. Remember when Santander bought Banco Popular for 1 euro? It wasn’t really a euro; it was assuming huge debt that caused other banks to withdraw.

The advantage of the P/E is that it’s easy to calculate, perfect for quickly comparing companies within the same sector, and works even if the company doesn’t pay dividends. The downside is that it only looks at one year of profits, doesn’t work with companies losing money, and in cyclical companies, it can be misleading: at the peak of the cycle, the P/E is low; at the trough, it’s high.

Value investors live by the P/E. They look for good companies at a good price, and a low P/E is their radar. Funds like Horos Value International or Cobas International have P/Es well below the average because that’s what they seek.

My advice: use the P/E as a comparative tool within the same sector and geography, but never as the sole criterion. Combine it with other indicators, spend time understanding the company, look at the business details. A serious investment based only on P/E will never work. But an investment where P/E is one of several indicators confirming your thesis, that one does have potential. The P/E is useful, but it’s just one piece of the puzzle.