Recently, many beginners have been asking me what the price-to-earnings ratio (P/E ratio) really is and how to tell whether a stock is expensive or cheap. In fact, the meaning of the P/E ratio is very simple: it shows how many years it takes for a stock to break even on its cost through the company’s profits.

The P/E ratio is also called the earnings multiple, abbreviated as PE or PER in English. Take the most common example: TSMC’s P/E ratio is roughly in the range of 13 to 24. This means that if you buy today, it would take about 13 to 24 years for the company to earn enough profit to recover your cost. Generally speaking, a lower P/E ratio usually indicates the stock price is cheaper, while a higher one indicates the market is willing to assign a higher valuation—possibly because people are optimistic about the company’s prospects.

Calculating the P/E ratio is actually very easy: divide the stock price by earnings per share, which is EPS. For example, if TSMC’s stock price is 520 and its EPS in 2022 was 39.2, then the P/E ratio is 520 divided by 39.2, which equals 13.3. Some people also use a company’s market value divided by net profit, but we usually use the first method.

What’s interesting is that P/E ratios can be broken down into several types. The static P/E ratio uses last year’s full-year EPS. Because this figure is fixed before the new annual report is released, changes in PE depend only on whether the stock price rises or falls. The trailing P/E ratio, also known as TTM (trailing twelve months), is calculated by summing the EPS of the most recent four quarters, allowing it to reflect the company’s situation more promptly. There is also the forward P/E ratio, which uses estimated future EPS, but the problem is that different institutions’ estimates differ, so its usefulness is relatively weaker.

So how do you determine whether a P/E ratio is high or low? The most practical approach is to compare it with companies in the same industry. For instance, by comparing TSMC with UMC, Taiwan Asia, you can see the relative level of their P/E ratios. Another method is to examine the company’s own history. TSMC’s current P/E ratio is around the middle-to-upper level over the past five years: it’s neither at bubble highs nor at lows, reflecting a healthy condition after the economic cycle improves.

I personally often use a P/E river chart to judge where the stock price stands. This chart shows 5 to 6 lines, each representing the stock prices corresponding to the historical highest and lowest P/E ratios. If the current stock price is near the lower lines, it usually indicates the stock may be undervalued and could be a decent buying opportunity. But remember: a low P/E ratio does not necessarily mean the stock will rise, and a high P/E ratio does not necessarily mean it will fall, because there are too many factors affecting stock prices.

However, P/E ratios also have clear limitations. First, it does not take the company’s debt into account. If two companies have the same P/E ratio but one has much higher liabilities than the other, the actual risks are completely different. Second, it’s difficult to define accurately what constitutes a high or low P/E ratio. Sometimes a high PE is because the company is temporarily facing difficulties but its fundamentals are still solid, and the market is still willing to hold the stock. Other times, it’s because investors are optimistic about future growth and move money in early. Finally, for start-up companies or biotech firms with no profits, the P/E ratio essentially cannot be calculated at all. In that case, you need to use other indicators such as the price-to-book ratio or the price-to-sales ratio.

So, although the meaning of the P/E ratio is simple, to truly use it well to judge investment opportunities, you still need to think from multiple angles. You can’t just look at whether the PE is high or low—you also need to consider industry characteristics, company fundamentals, market sentiment, and more for a comprehensive assessment. That’s how you can find stocks that genuinely have investment value.