Recently, I found that many people around me don’t understand the Price-to-Earnings ratio when investing in stocks. Actually, it’s not that complicated—it’s simply an indicator used to judge whether a stock price is cheap or expensive.

Simply put, the Price-to-Earnings ratio (PE or PER) represents how many years it takes for a stock to break even. For example, TSMC’s PE is around 13, meaning that if you buy now, it would take 13 years for the company’s profits to pay back your investment. The calculation is straightforward: divide the stock price by earnings per share (EPS). This is the most commonly used method. For instance, TSMC’s stock price is 520, and its EPS in 2022 was 39.2, so the PE equals 520 divided by 39.2, which comes out to about 13.3.

However, there are several types of PE ratios. Some use last year’s annual EPS, called static PE; some use the latest four quarters of EPS, called rolling PE or TTM; and others use estimated EPS, called dynamic PE. To be honest, the accuracy of the estimated version is usually not great, because each institution makes different forecasts.

So what PE level is considered reasonable? The most practical approach is to compare it with peers. Different industries vary a lot. For example, the PE in the automotive industry can be as high as 98, while in shipping it may be only 1.8—so you can only compare with companies in the same industry. If you compare TSMC with United Microelectronics, TSMC’s PE will be higher. Another method is to look at the company’s own history: whether its current PE is high or low relative to its past, so you can judge whether it’s a good time to buy.

Many people like to use a PE ratio “river chart” to intuitively judge whether stock prices are high or low. On the stock chart, they draw several lines using different PE multiples multiplied by EPS. The top line corresponds to the highest historical PE and its corresponding stock price, while the bottom line corresponds to the lowest historical PE and its corresponding stock price. If the current stock price is in the lower area, it usually suggests the stock is undervalued.

But here’s something to note: the PE ratio has no inevitable link to whether the stock price rises or falls. A low PE doesn’t necessarily mean the price will go up, and a high PE doesn’t necessarily mean it will go down. The market may be willing to assign high valuations to certain companies, often because it expects their future development. For example, many tech stocks have high PE ratios, yet their stock prices keep rising.

The PE ratio also has its limitations. First, it ignores a company’s debt. With the same EPS and PE, a company with higher liabilities is actually riskier. Second, it’s hard to accurately determine whether a PE is high or low. Sometimes a high PE is due to temporary difficulties but solid fundamentals; other times it’s because the market is optimistic about future growth and is positioning ahead of time. Finally, for startups or companies that haven’t turned a profit yet, you basically can’t calculate a PE at all—in that case, you need other indicators such as PB or PS.

Overall, the PE ratio is a very important reference indicator for investing. When combined with EPS data, it can help you evaluate whether a stock is worth buying more rationally. However, never treat it as the only standard—you should consider a range of factors as well, such as the company’s fundamentals and industry prospects.