Recently, a friend asked me how to tell if a stock is expensive or cheap.

Actually, this involves the most important indicator — the Price-to-Earnings ratio (P/E ratio).
I found that many beginners are a bit fuzzy on this concept, so today I’ll explain it thoroughly.

The P/E ratio is also called the Price-to-Earnings ratio, in English it’s PE or PER, simply put, it tells you how many years it will take to recoup your investment when buying a stock.
It represents the ratio between the stock price and the company's earnings per share.
For example, if a stock’s P/E ratio is 13, it means at the current profit rate, it will take 13 years to earn back your principal.

How do you calculate it?
The most common method is to divide the stock price by earnings per share, which is the P/E formula: PE = Stock Price / EPS.
For instance, if the stock price is 520 yuan and EPS is 39.2 yuan, then the P/E ratio is 520 ÷ 39.2 ≈ 13.3.
Another way is to use the company's market value divided by net profit; the principle is the same.

It’s important to note that there are different ways to calculate the P/E ratio.
The most common is the static P/E, which uses the EPS from the past full year.
There’s also the rolling P/E, which sums the EPS from the most recent four quarters, providing a more timely reflection of the company's profitability.
Additionally, there’s the forward P/E, which uses analyst estimates of future EPS, but this number is often less accurate because different institutions have different forecasts.

Generally, a lower P/E ratio indicates the stock is cheaper, while a higher P/E suggests the market is willing to assign a higher valuation, possibly because of optimistic outlooks.
But this isn’t absolute — a high P/E can also mean the market expects rapid growth in the future.

To judge whether a stock’s P/E ratio is reasonable, there are two methods.
First, compare it with other companies in the same industry, because P/E ratios vary greatly across sectors — tech stocks might have very high P/Es, while traditional industries might be lower, so only compare within the same industry.
Second, look at the company’s historical P/E trend.
If the current P/E is at a median level historically, it suggests the price is relatively reasonable.

There’s a very practical tool called the P/E river chart, which visually shows where the stock price sits at different P/E levels.
Derived from the P/E formula, it displays different price bands, making it easy to see whether the current price is overvalued or undervalued.
When the stock price is below the river chart, it’s usually a good buying opportunity.

However, honestly, the P/E ratio has its limitations.
First, it ignores the company’s debt situation — two companies with the same P/E but different debt levels have very different risks.
Second, it’s hard to accurately judge when a P/E is high or low because it depends on growth expectations and market sentiment.
Finally, for startups or biotech stocks that aren’t profitable yet, the P/E ratio isn’t applicable; in these cases, other indicators like Price-to-Book or Price-to-Sales ratios should be used.

Therefore, the P/E ratio is just a tool for investment reference; it shouldn’t be relied on alone.
A low P/E doesn’t necessarily mean the stock will rise, and a high P/E doesn’t guarantee it will fall.
The key is to understand the company’s fundamentals and market expectations.
Learning to analyze with the P/E formula, combined with other indicators, will help you more comprehensively evaluate whether a stock is worth buying.