Is a high or low P/E ratio better? Mastering this indicator allows you to determine whether a stock is cheap or expensive.

When investing in stocks, many people have heard of the term “Price-to-Earnings Ratio,” but few truly understand it. What exactly is the P/E ratio used for? Can its high or low levels really determine whether a stock is good or bad? This article will start from the most basic concepts and guide you step by step to understand this essential investment indicator.

The Code of Stock Valuation: What Is the P/E Ratio Anyway?

The P/E ratio, also known as the Price-to-Earnings Ratio, abbreviated as PE or PER(Price-to-Earning Ratio). To explain it plainly, it answers a core question: How many years of company profits are needed to recover the current stock price?

For example, suppose a company’s current P/E ratio is 15. This means it would take 15 years of profits at the current level to reach its market value. Conversely, it implies that buying this stock would require 15 years to break even. A lower P/E ratio indicates that you are buying the company’s earnings at a relatively cheaper price; a higher P/E ratio suggests you are paying a premium for future growth potential.

Three Types of P/E Ratios You Must Distinguish

In practice, the P/E ratio can be categorized into three types based on the profit data used, each with its own purpose and limitations.

Static P/E Ratio: Based on Historical Financial Data

Static P/E = Stock Price ÷ Annual Earnings Per Share(EPS)

This is the most basic calculation, using the profit data from the most recent full year. Since annual EPS remains fixed until new financial reports are released, fluctuations in the P/E ratio are purely due to changes in stock price. This is why it’s called “static.”

For example, TSMC’s annual EPS is NT$39.2, and the current stock price is NT$520. The static P/E = 520 ÷ 39.2 ≈ 13.3 times. This number tells you where the current stock price stands based on last year’s confirmed profits.

The advantage is that the data is the most accurate and stable; the drawback is that it reacts slowly and may not reflect the company’s latest operational status in real-time.

Rolling P/E: Updated with the most recent four quarters’ data

Rolling P/E(TTM) = Stock Price ÷ Sum of EPS over the last four quarters

TTM stands for “Trailing Twelve Months,” meaning the calculation covers the most recent 12 months. Since listed companies release quarterly reports, this indicator can more promptly reflect the company’s latest profit trends.

Suppose TSMC just announced a quarterly EPS of NT$5. The sum of EPS over the last four quarters is: 9.14 + 10.83 + 11.41 + 5 = NT$36.38. Then, the rolling P/E = 520 ÷ 36.38 ≈ 14.3 times.

Compared to the static P/E of 13.3, the rolling P/E better reflects the company’s current profit situation. If this number is rising, it indicates profit decline; if falling, it may suggest profit improvement.

Dynamic P/E: Forward-looking price prediction

Dynamic P/E = Stock Price ÷ Estimated Annual EPS

This method uses EPS forecasts from brokerage firms or research institutions. For example, if the forecasted EPS for TSMC in 2024 is NT$35, then the dynamic P/E = 520 ÷ 35 ≈ 14.9 times.

The advantage of the dynamic P/E is that it can anticipate market expectations for the company’s future performance. However, the problem is that forecasts from different institutions can vary widely—some overly optimistic, others too conservative—so caution is needed when using this metric.

Is a High or Low P/E Better? The Key Is How to Compare

Simply looking at the P/E number itself isn’t very meaningful; it must be placed within the correct comparison framework to be valuable.

Horizontal Industry Comparison: Find Relative Highs and Lows

P/E ratios vary greatly across industries. High-growth sectors like technology and pharmaceuticals tend to have higher P/E ratios because the market expects significant future growth; traditional manufacturing and financial sectors usually have lower P/E ratios.

For example, in the semiconductor industry, TSMC, UMC, and Powertech have P/E ratios of 13, 8, and 47 respectively. When comparing, it’s essential to compare within the same industry to determine which stocks are relatively cheap or expensive. A high P/E isn’t necessarily bad—it may reflect market recognition of a company’s competitiveness and growth prospects; a low P/E isn’t always an opportunity—it could indicate underlying difficulties.

Vertical Time Comparison: Recognize Valuation Peaks and Troughs

Compare the current P/E with the company’s historical P/E data to understand where the current valuation stands.

For example, if TSMC’s current P/E is 13, and over the past five years, 90% of the time the P/E was above 15, then the current valuation is relatively cheap and might be a buying opportunity. Conversely, if most of the time the P/E was below 12 and now it’s at 15, the stock price has already risen.

This comparison method is objective and data-supported; however, it cannot predict future performance and may lead to the trap of “buying high,” especially since high valuation zones can also signal the company is entering a growth phase.

P/E River Map: Visualize Stock Price Highs and Lows at a Glance

If the P/E ratio is a number, then the P/E river map is a visual tool that represents this number graphically. By combining the company’s historical highest and lowest P/E ratios with current EPS, you can intuitively see whether the current stock price is overvalued or undervalued.

The river map typically consists of 5 to 6 lines: the top line corresponds to the historical highest P/E-based stock price, the bottom line to the historical lowest P/E-based stock price, and the middle lines to various median zones. When the stock price is in the lower zone, it often indicates an undervaluation opportunity; when in the upper zone, it may signal risk.

Note that the river map is only a reference tool and should not be the sole basis for buy or sell decisions. Undervaluation doesn’t guarantee a rise, and overvaluation doesn’t mean an immediate decline. It should be combined with company fundamentals, industry cycles, and other factors.

The Three Major Pitfalls of the P/E Ratio You Must Recognize

Although the P/E ratio is a commonly used valuation metric, it has obvious limitations.

First, it ignores the company’s debt burden. Two companies with identical P/E ratios can have vastly different risk profiles—one with ample assets and low debt, the other highly leveraged. During economic downturns or rising interest rates, the risks differ significantly. Companies with substantial assets often have higher stock prices, but that doesn’t mean they are cheaper; it just indicates lower risk.

Second, it’s difficult to define what constitutes a high or low P/E precisely. A high P/E might be due to temporary earnings dips, with the company still fundamentally sound; it could also reflect market anticipation of future growth; or it might be a bubble. There’s no absolute standard—judgment depends on specific circumstances.

Third, it cannot be used for unprofitable companies. Many startups and biotech firms are not yet profitable, rendering the P/E ratio useless for them. In such cases, other metrics like Price-to-Book (PB) or Price-to-Sales (PS) ratios are needed.

The Roles of PE, PB, and PS Ratios

Different types of companies require different valuation metrics. Established profitable companies are best evaluated with PE; cyclical or loss-prone companies are better assessed with PB to gauge asset value; unprofitable growth companies are often evaluated with PS to analyze revenue scale. Using all three together provides a more comprehensive valuation picture.

Mastering the P/E ratio is just the starting point of investing. What’s more important is understanding its applicable conditions and limitations, then continuously testing and adjusting your judgment standards through practical experience.