Stock Investment Must-Read: How to Determine if a Stock's Price is High or Low Using the Price-to-Earnings Ratio

What is the biggest fear when investing in stocks? It’s chasing high prices and getting trapped. To avoid this tragedy, the Price-to-Earnings Ratio (PE) is the most practical screening tool in your hands. Many experienced investors often say, “What is this stock’s PE ratio now? The valuation is about right,” and in fact, they are using this indicator to judge buy and sell points. So, how do you interpret and use the PE ratio?

What is the PE ratio? Simply put, it’s “the payback period”

The PE ratio, also called the Price-to-Earnings Ratio, abbreviated as PE (Price-to-Earning Ratio), appears as a number on the surface, but it actually answers a very important question: How many years will it take for the earnings to recover the initial investment?

For example, TSMC’s current PE is about 13, meaning: assuming TSMC’s annual profit remains unchanged, it would take 13 years to recoup the initial investment through earnings. The lower the PE, the faster the “payback period,” usually indicating the stock is cheaper; the higher the PE, the longer the payback, which may suggest the stock is overvalued.

This is also why investors often say, “PE is an important indicator to judge whether a stock is expensive or cheap,” because it directly tells you whether the current price is reasonable.

How to calculate the PE ratio? It’s very simple

The most common formula is: PE = Stock Price ÷ Earnings Per Share (EPS)

You can also calculate it from a macro perspective: PE = Market Capitalization ÷ Net Profit, and the result is the same.

For example: If TSMC’s current stock price is NT$520, and its EPS in 2022 was NT$39.2, then PE = 520 ÷ 39.2 = 13.3.

It’s that simple, but to use it effectively, you need to understand that there are different “versions” of PE.

Which three types of PE should you look at?

The problem with PE is: Using earnings data from different periods to calculate the same stock can yield different PE values. Therefore, there are three types:

Static PE: calculated using last year’s results

Static PE = Stock Price ÷ EPS of the past year

This is the most basic method. Using the EPS of the entire past year, the data is the most stable and transparent because last year’s financial report has already been published, with no estimation involved.

The downside? It reflects past conditions, not the current situation. If a company’s performance has significantly increased or decreased this year, static PE won’t keep up.

Rolling PE: calculated using the most recent four quarters

Rolling PE (TTM) = Stock Price ÷ Sum of EPS of the last 4 quarters

This improves upon static PE. Listed companies release quarterly reports, and the rolling PE sums the latest four quarters’ EPS, providing a more timely reflection of the company’s recent performance.

For example, if TSMC announced an EPS of NT$5 in Q1 2023, and the previous four quarters are: Q2 2022 (NT$9.14) + Q3 2022 (NT$10.83) + Q4 2022 (NT$11.41) + Q1 2023 (NT$5) = NT$36.38

Then, the rolling PE = 520 ÷ 36.38 ≈ 14.3

Compare this with static PE of 13.3; the rolling PE is higher, indicating it better reflects the current situation.

Dynamic PE: calculated using forecasted earnings

Dynamic PE = Stock Price ÷ Estimated EPS for this year or next year

This uses forecasts from brokerages or research institutions. In theory, if a company’s performance is expected to grow significantly next year, using the higher estimated EPS will lower the PE, making it look cheaper.

But there’s a big pitfall: Different institutions’ forecasts vary widely, sometimes even wildly. Some are optimistic and forecast high; others are pessimistic and forecast low. This makes the dynamic PE less reliable as a reference. Many retail investors believe overly optimistic forecasts and end up trapped.

Recommendation: prioritize static and rolling PE, and treat dynamic PE as a reference.

How to judge if a PE is reasonable? Benchmark against peers and historical levels

When you see a PE number, how do you know if it’s high or low? There’s no absolute standard, but two reference methods:

Method 1: Compare with industry peers

PE ratios vary greatly across industries. For example, in February 2023, the PE of listed Taiwanese companies by industry:

• Automotive: 98.3 (high-growth industry)
• Shipping: 1.8 (typical cyclical industry)

Obviously, you can’t compare these two industries directly. The correct approach is to find companies within the same industry and similar business models for comparison.

For example, TSMC (PE=13), UMC (PE=8), and Taiwan Semiconductor (PE=47). TSMC’s PE is between the two, so it’s not particularly expensive.

Method 2: Look at the company’s historical PE

Compare the current PE with the past few years to judge whether it’s cheap or expensive.

Taking TSMC as an example, its current PE is 13, but compared to its past 5-year PE trend, 13 is below 90% of its historical levels. This indicates that the current valuation is relatively low, possibly a good buying point.

PE River Chart: Instantly see if a stock is overvalued or undervalued

Is there a more intuitive way to judge the stock price position? Yes, the PE River Chart.

The principle is simple: Stock Price = EPS × PE

The river chart typically draws 5 to 6 lines, each representing different PE multiples:

• The top line uses the historical highest PE (e.g., 30x)
• The bottom line uses the historical lowest PE (e.g., 8x)
• The middle lines use average PE values

By seeing where your current stock price falls relative to these lines, you can tell if the stock is expensive, reasonable, or cheap.

For example, TSMC’s current price is between the PE lines of 13 and 14.8, in the lower zone, indicating undervaluation. But remember, being undervalued doesn’t guarantee it will rise; you still need to consider fundamentals, industry outlook, and other factors.

The three major pitfalls of PE, avoid these traps

While PE is useful, it has limitations. Be especially cautious:

Trap 1: Ignoring a company’s debt risk

PE only looks at profitability, completely ignoring debt. Two companies may have the same EPS, but one is financed with equity, the other with debt, and their risks are very different.

Companies with low debt are more resilient during economic downturns or rising interest rates. For the same PE, a low-debt company is often a better buy. At this point, simply looking at PE isn’t enough; you should also check the company’s debt ratio and cash flow.

Trap 2: High PE doesn’t necessarily mean expensive

Sometimes, a high PE is due to poor short-term performance but with significant growth potential in the future, and the market has priced in this optimism; other times, a high PE indicates a bubble, and it should be sold. The reason behind a high PE can be completely different, and so should your judgment.

This is why there’s no absolute standard for high or low PE; it must be evaluated in the context of the company’s specific situation.

Trap 3: Companies that haven’t made money yet can’t be evaluated with PE

Many startups and biotech stocks are still losing money or just starting to turn a profit, with no stable earnings data. Using PE in these cases is meaningless. Instead, consider other metrics like Price-to-Book (PB) or Price-to-Sales (PS).

The three main valuation indicators: PE, PB, PS, each with its use

Once you understand PE, you also need to know when not to use it:

Practical advice: Use PE for mature stocks, add PB for cyclical stocks, and PS for startups. Combining these three helps avoid pitfalls.

Final thoughts

Investing isn’t a math problem; PE is just a tool, not a decisive factor. It can help you identify undervalued stocks, but whether you make money depends on your understanding of the company’s fundamentals, industry outlook, and market sentiment.

Remember: stocks with low PE don’t necessarily go up, and stocks with high PE don’t necessarily go down. But if you use PE well, at least you can avoid buying at the most expensive points.