When I was researching stock valuation recently, I found that many beginners are confused by the price-to-earnings ratio. In fact, calculating the P/E ratio is not complicated at all, but it really is one of the most important indicators for assessing whether a stock is expensive, so I’d like to share my understanding with everyone.

The price-to-earnings ratio is also known as the P/E ratio. In English, it’s PE or PER. Simply put, it tells you how many years it would take for a stock to “break even.” Taking TSMC as an example: if the P/E ratio is 13, it means that the profit from now would take 13 years to earn back the principal you invested. The lower the P/E ratio, the cheaper the stock price; conversely, the higher the P/E ratio, the more expensive it is.

As for the method for calculating the P/E ratio, the most commonly used approach is to divide the stock price by earnings per share—EPS. For example, if TSMC’s share price is 520 and its EPS in 2022 was 39.2, then the P/E ratio equals 520 divided by 39.2, which is approximately 13.3. That’s it—so simple.

But you should know that there are actually different ways to calculate the P/E ratio. Some people use last year’s full-year EPS; this is called the static P/E ratio. Some use the sum of the most recent four quarters of EPS; this is called the rolling P/E ratio or TTM. Others use estimated EPS; this is called the dynamic P/E ratio. Each of the three methods has its own pros and cons: the static PE has strong lag, the rolling PE is more up-to-date but doesn’t show the future, and the dynamic PE can reflect expectations but is not very accurate.

So what P/E ratio is considered reasonable? In my experience, you can look at it from two directions. First, compare it with companies in the same industry, because the differences in P/E ratios across industries are too large. For instance, the PE in the automobile industry might be 98, while in shipping it might be only 1.8—comparing these two is basically meaningless. Second, look at the company’s own historical P/E, to judge whether the P/E ratio you get today is at a high level or a low level, which can help you determine whether the stock price is reasonable.

If you want to see whether a stock price is high or low more intuitively, you can use a P/E river chart. This chart estimates the price range by using the historical highest and lowest P/E ratios, so you can immediately tell whether the current stock price is overvalued or undervalued. However, you should note that a low P/E doesn’t necessarily mean the stock price will rise, and a high P/E doesn’t necessarily mean it will fall, because the market is often willing to assign higher valuations when it is optimistic about the company’s future.

Although the P/E ratio is useful, it also has limitations. First, it only looks at equity value and ignores the company’s debt situation. With the same P/E, a company with less debt generally carries lower risk. Second, it’s difficult to accurately judge whether a P/E is high or low, because a high P/E could reflect temporary difficulties—or it could be the result of positioning in advance for future growth. Third, for loss-making startups with no profits, the P/E ratio simply can’t be used; at that point, you should evaluate using PB or PS.

When I calculate P/E ratios and select stocks, I pair them with other indicators as well. PE looks at profitability, PB looks at asset value, and PS looks at revenue scale—only when these three indicators confirm each other can you make a better judgment. I hope this sharing helps you understand the P/E ratio tool more effectively.