P/E Ratio: How Investors Can Assess the Fair Value of Stocks

Introduction

The price-to-earnings ratio (P/E) is one of the most popular tools in the stock market. If you have been planning to invest in stocks, you have probably heard this term. But what does it actually mean and how should it be properly used in analysis?

How the P/E Ratio Works: The Basic Idea

Essentially, the P/E ratio shows how much money investors are willing to spend to earn one dollar of a company's profit. This ratio provides a quick assessment of whether the stock is overvalued, undervalued, or fairly valued.

Mathematically, it's simple: the current stock price is divided by the earnings per share (EPS) for a certain period. Earnings per share is calculated as the net profit of the company (after taxes and payment of preferred dividends), divided by the weighted average number of shares outstanding.

Diversity of P/E Types: Choosing the Right Metric

The P/E ratio does not have a universal format. Depending on which data is used, different perspectives can be obtained:

Historical P/E is based on a company's actual earnings over the last 12 months. This is the most reliable metric as it reflects actual results rather than forecasts.

Forecast P/E is calculated based on expected earnings for the next 12 months. Here, analysts rely on their own estimates and expectations regarding the future development of the company. This indicator is more optimistic, but also carries more risk.

Basic P/E is simply the current price divided by the last EPS, without any comparisons to other companies.

Relative P/E puts the ratio in context: it compares it to the average for the industry or to the company's past values. This helps to understand whether the stock is expensive on its own or relative to competitors.

What P/E Tells You: Interpretation of the Indicator

Reading the P/E ratio requires context. A high value often means that the market has optimistic expectations for future growth – investors are willing to pay a premium for the prospect. A low value, on the other hand, may signal an undervalued stock or that the company is facing challenges.

But “high” or “low” depends on the sector. Technology companies often have higher P/E ratios due to the potential for exponential growth, while utility companies traditionally have lower ratios due to stable but more modest earnings.

Practical Application of P/E

The P/E ratio is a convenient filter for investors looking for potentially undervalued stocks. It is especially useful for comparing companies within the same sector: if two similar companies have vastly different ratios, it is worth investigating the reason.

In addition, investors use P/E for:

• Stock screening – finding securities that are potentially undervalued based on current standards.
• Trend Analysis – comparing the company's P/E over time shows how the market's perception of the company has changed.
• Benchmarking – comparing with the industry average helps to determine whether the stock price is fair.

Disadvantages of the P/E Ratio: When It Doesn't Work

Despite its popularity, P/E has serious limitations:

Problem with negative profits: if a company is unprofitable, the P/E ratio simply cannot be calculated. This makes it unsuitable for young startups or companies in crisis.

Ignoring Growth: Two P/E ratios may look the same, but the companies behind them can be very different. One may have the potential for rapid growth, while the other may be stagnant. Context matters.

Manipulation Potential: companies sometimes resort to accounting tricks to inflate reported profits, which artificially lowers the P/E.

Narrow perspective: the P/E ratio says nothing about a company's debt, the quality of cash flows, management, or competitive advantages. A full analysis requires considering other indicators – profitability, debt level, operating cash flows.

Therefore, investors should use P/E as part of a comprehensive analysis, rather than as the sole criterion.

Sector Differences: Why P/E Varies Significantly

P/E ratios vary significantly depending on the type of business. This is a key point that is often overlooked by newcomers.

In the technology sector, companies often trade at higher P/E ratios as investors place bets on scaling and future dominance. In contrast, utility companies have low P/E ratios because their business is predictable and stable, but slow-growing.

Comparing a technology company to a utility company solely based on P/E is incorrect. It is necessary to compare within the same industry.

P/E and cryptocurrencies: is the metric applicable to BTC, Ethereum, and other assets?

Many ask: can the P/E ratio be used to evaluate Bitcoin, Ethereum, or other cryptocurrencies? The answer is no, or more precisely, not directly.

The P/E ratio was developed for companies that publish clear earnings reports. Most cryptocurrencies do not have official earnings in the traditional sense. Bitcoin does not generate “earnings” in the classical sense. Ethereum as a platform distributes fees, but that is not the same as corporate profits.

However, in decentralized finance (DeFi), the first attempts to adapt similar logic are emerging. Some DeFi platforms that genuinely earn from fees are being evaluated by analysts approximately like companies, looking at the fee income. But this is still an experimental approach and has not gained widespread adoption.

Conclusion

The price-to-earnings ratio is a time-tested metric that provides a quick assessment of a stock's attractiveness. It is an excellent starting point for those beginning to analyze securities. However, it is important to remember its limitations: use the P/E ratio alongside other indicators, consider industry specifics, and always look at the context. No single ratio tells the whole story.