I've noticed for a while that many investors talk about the P/E ratio without really understanding what they are measuring with that metric. It’s one of those indicators you see everywhere but that few know how to interpret correctly, so I decided to delve into how it actually works.

Basically, the P/E shows the relationship between what a stock costs on the market and what the company earns. The initials stand for Price/Earnings Ratio, or in other words, Price/Profit Ratio. If a company has a P/E of 15, it means that theoretically, its annual profits would need 15 years to equal its market value. It sounds simple, but there’s much more behind it.

The calculation is straightforward: take the market capitalization and divide it by the net profit. Or, if you prefer on a per-share basis, divide the share price by earnings per share. Either way, you get the same result. What’s interesting is that this P/E behaves very differently depending on the company.

Let’s look at an example I saw a few years ago. Meta (Facebook) had a P/E that was decreasing while the stock price was rising, meaning it was earning more profits each time. But at the end of 2022, something happened: the stock fell even though the P/E kept decreasing. Why? Interest rates were rising, and the market lost confidence in tech companies. With Boeing, it was different: the P/E stayed within a range while the stock moved up and down with the market.

Now, here’s where it gets interesting. The P/E mainly helps compare companies within the same sector and detect if they are overvalued or not. A low P/E can mean a buying opportunity, but beware: it can also be a sign that profits are about to fall. A high P/E might indicate that the market expects big things, or simply that we’re in a bubble.

Analysts usually prefer a P/E between 10 and 17 as an optimal zone. Below 10 is attractive but suspicious. Between 17 and 25, signs of overvaluation start to appear. Above 25, you see both the best opportunities and the worst disasters.

But here’s the crucial part many forget: the P/E isn’t everything. Banking and industrial companies tend to have naturally low P/Es. Tech and biotech firms often have very high P/Es. ArcelorMittal has a P/E around 2.58, while Zoom Video reached 202. Comparing both with the same criteria is a mistake. You need to look at companies within the same sector, same market, same conditions.

Additionally, the P/E only looks at profits from one year. Some prefer the Shiller P/E, which uses the average inflation-adjusted profits over the last 10 years. An interesting idea, but it also has critics. Then there’s the normalized P/E, which adjusts for debt and uses free cash flow instead of net profit. Each variant gives you a different perspective.

One thing I learned is that a consistently low P/E isn’t always a good sign. If a company has a very low P/E for years, it’s probably because its management is terrible and it’s closer to bankruptcy than anything else. History is full of companies with good P/Es that disappeared.

Value investors use the P/E a lot because they look for good companies at a good price. You see value funds with P/Es of 5 or 7, well below the sector average. It makes sense: if everyone else is paying more, they’re buying cheap.

My recommendation: use the P/E, but never alone. Combine it with other metrics like ROE, ROA, price/book value. Study the company’s real numbers, not just the bottom line. Sometimes a high profit comes from selling an asset, not from the core business. And above all, always compare apples to apples, don’t mix numbers from different sectors in the same analysis.

In conclusion, the P/E is a practical and easy-to-calculate tool, but it’s just that: a tool. Investing solely based on P/E never works. Spend at least 10 minutes truly understanding what’s behind those numbers and build a serious analysis. The P/E is the starting point, not the destination.