To be honest, the biggest fear when investing in stocks is not knowing whether a company’s stock is truly expensive or cheap. I used to think the same way at first, but later I realized that the Price-to-Earnings ratio is really that important.

The Price-to-Earnings ratio is also called the earnings multiple; it is abbreviated as PE or PER. In essence, it tells you how many years it would take for this company to earn back its current market value. For example, Taiwan Semiconductor Manufacturing Company (TSMC)’s PE ratio fluctuates between 13 and 15, meaning that if you buy TSMC’s stock now, it would take roughly 13 to 15 years to break even. A lower PE ratio usually indicates a cheaper stock price, while a higher PE ratio means the market is willing to assign a higher valuation—possibly because the company has good prospects and strong growth potential.

The most basic way to calculate it is to divide the stock price by earnings per share, meaning the stock price divided by EPS. Taking TSMC as an example: if the stock price is 520 yuan and the EPS in 2022 is 39.2 yuan, then the PE ratio equals 520 divided by 39.2, which comes out to 13.3. This number looks simple, but the meaning behind it is actually very deep.

When it comes to the types of PE ratios, they can basically be divided into two major categories. One is historical PE, including static PE and trailing PE. The other is estimated PE, also known as forward PE. Static PE uses last year’s annual EPS, while trailing PE uses the sum of the latest 4 quarters of EPS. The benefit of this approach is that it can reflect the company’s situation more promptly. As for estimated PE, it uses analysts’ forecasts of future EPS. Although it lets you see the future, its accuracy is often not strong enough.

So what PE ratio is considered reasonable? I think the best approach is to compare it with companies in the same industry. PE ratios vary enormously across different industries. For example, the PE in the automotive industry might be as high as 98, while in shipping it could be only 1.8—so cross-industry comparisons are basically meaningless. For TSMC, you can compare it with United Microelectronics Corporation (UMC) and Powerchip Semiconductor Manufacturing Corporation (PSMC) to see whether its PE is high or low. Another method is to look at the company’s historical PE trend: if the current PE is in the upper-middle range over the past five years, it usually indicates that the stock price is in a healthy recovery phase.

In practice, many people use a PE river chart to judge whether a stock is expensive or cheap. This chart shows 5 to 6 lines. The top line is the stock price calculated from the historical highest PE, and the bottom line is the stock price calculated from the historical lowest PE. If the stock price is in the lower zone, it usually means it may be undervalued and could be a decent time to buy. But remember, a low PE ratio does not necessarily mean the stock price will rise, and a high PE ratio does not necessarily mean the stock price will fall—because there are too many factors that affect stock price movements.

However, the PE ratio also has its limitations. First, it only looks at equity value and ignores the company’s debt situation. Even if two companies have the same PE ratio, one with low debt and one with high debt carry completely different risks. Second, it is difficult to accurately judge whether a PE ratio is high or low, because a high PE could be due to the company temporarily facing headwinds, or it could reflect the market’s optimism about its future growth. Finally, for new startups or biotech companies that have not started generating profits yet, the PE ratio simply can’t really be used—in that case, you need to rely on other indicators such as the price-to-book ratio or the price-to-sales ratio.

Besides the PE ratio, the PB and PS indicators are also very commonly used. PE is suitable for evaluating companies with stable earnings, PB is suitable for cyclical companies, and PS is suitable for companies that have not started earning profits yet. Once you master these valuation tools, you can find investment targets that better fit your needs more rationally.