Fundamental Analysis: Decoding the PER and Its True Value in Stock Selection

If you are an investor looking to identify undervalued or overvalued companies, the P/E ratio is probably the first indicator you check. However, this ratio that appears on every financial platform is much more complex than it seems at first glance. Let’s see how it really works and why so many analysts consider it indispensable for making investment decisions.

What’s behind this metric that everyone consults?

The P/E ratio (Price/Earnings Ratio) is the quotient between a company’s total stock market price and its annual net earnings. In other words, it indicates how many years of current profits would be needed to recover the investment made in the company. If a company has a P/E of 15, it means you would pay 15 years of profits to own it completely.

This metric is part of the set of fundamental indicators that every analyst must master, along with EPS (Earnings Per Share), P/BV (Price to Book Value), EBITDA, ROE, and ROA. Its relevance lies in the fact that it not only allows comparisons between companies but also reflects how the market values future profit growth.

What’s interesting is to observe how the P/E behaves very differently depending on each case. Let’s take the example of Meta Platforms: for years, as profits multiplied, the P/E decreased consistently and the stock price rose. It was a reflection of an expanding company generating higher earnings year after year. But at the end of 2022, the pattern broke: the P/E declined, but the stock fell. The reason? Tech markets faced pressure from the FED’s interest rate hikes, regardless of profits continuing to improve.

Practical calculation: two paths to the same destination

There are two equivalent ways to calculate the P/E, each useful depending on the available context:

Method 1 - At the company level: P/E = Market capitalization of the company / Total net profit

Method 2 - Per share: P/E = Share price / Earnings per share (EPS)

Both formulas give the same result because the numbers are proportionally related. The required information is easy to obtain on any financial platform, so calculating the P/E on your own is as simple as a basic division.

Practical example 1:

A listed company has a market capitalization of $2.6 billion and generated net profits of $658 million in the last fiscal year.

P/E = 2,600 / 658 = 3.95

Practical example 2:

You consider investing in a company where each share costs $2.78 and earnings per share are $0.09.

P/E = 2.78 / 0.09 = 30.9

Where to find these numbers without hassle

Any serious financial portal (Infobolsa, Yahoo Finance, Google Finance) prominently displays the P/E along with other data such as market cap, EPS, and 52-week price range. Some use the term “P/E” and others “PER” (more common on US platforms), but they refer exactly to the same concept.

Interpretation depends on context

The standard guide suggests:

• P/E between 0 and 10: Generally attractive, although it may indicate future profit problems
• P/E between 10 and 17: The comfort zone for analysts, suggests reasonable growth without bubble
• P/E between 17 and 25: Sign of accelerated growth or overvaluation warning
• P/E above 25: Double reading: either very optimistic projections or a speculative bubble

However, this interpretation is deceptively simple. Not all companies with low P/E are bargains, nor are all with high P/E speculative. The sector matters greatly: a metallurgical company like ArcelorMittal has a P/E of 2.58, while a software company like Zoom reaches 202.49. Both numbers can be “correct” within their respective sector context.

Variants of the P/E: when the standard measure isn’t enough

Shiller’s P/E: expanding the time horizon

The main criticism of the conventional P/E is that it only considers profits from one year, which can be misleading if that year was atypical. Shiller’s P/E corrects this by using the average profits of the last 10 years, adjusted for inflation. The idea is that this longer time horizon allows for a more accurate projection of profits over the next 20 years.

Normalized P/E: cleaning up accounting

Sometimes, reported profits hide operational reality. The normalized P/E adjusts the equation by subtracting liquid assets, adding debt, and replacing net profit with Free Cash Flow. This refinement is especially useful in cases of acquisitions with significant debt, where the apparent price can be misleading.

P/E in action: how investors really use it

Specialized value investing funds (seeking good companies at a fair price) tend to have considerably lower P/E ratios than the market average. For example, an international value fund typically operates with a P/E of 7.24 compared to 14.55 for the sector, demonstrating systematic selection of undervalued companies.

P/E works as a comparison tool between companies in the same sector and geography, but it should never be the only criterion. Many companies with low P/E are close to bankruptcy because no one trusts their management. History is full of cases of companies with attractive ratios that disappeared from the market.

Limitations you should know

• Only considers one year of profits, which can distort during economic cycles
• Is inapplicable to unprofitable companies
• Reflects the present, not the future: ignores management changes, technological disruption, or emerging problems
• In cyclical companies (construction, mining), the P/E rises when the crisis hits and falls during euphoric moments, opposite to what you would expect

P/E never works alone

A serious investment analysis never relies solely on P/E. It should be combined with:

• EPS: Verify that profits are actually growing
• Price/Book Value: Compare price with real assets
• ROE and ROA: Measure the company’s efficiency in generating profits
• Income and margin analysis: Ensure profits come from the business, not asset sales
• Balance sheet health: Debt, liquidity, and capital structure

The sector factor: the golden rule many forget

Comparing a bank’s P/E with that of a biotech is like comparing apples to oranges. Industrial and financial sectors naturally have low P/E (more predictable profitability), while technology and biotech operate with high P/E (promises of future growth). A proper analysis always compares “apples with apples.”

Value Investing and the obsession with P/E

Value investors see the P/E as a way to measure whether the market is being irrational. When a company’s P/E is well below the sector average without an apparent fundamental reason, there is an opportunity. But this requires deep research: why does the market distrust? Is it overcorrection or a correct judgment?

What really matters

The P/E is useful, practical, and widely available, but it’s a starting point, not an endpoint. A serious investment decision requires:

1. Selecting companies within the same sector
2. Reviewing the P/E in a historical context (Is it at highs, lows, or average?)
3. Combining with other financial ratios
4. Analyzing the company’s actual operational health
5. Understanding what generates those profits (Operations or asset sales)
6. Investigating management changes, competition, regulation

The P/E is the initial traffic light, but you shouldn’t invest based only on its color. Take the time to understand why a stock has that specific P/E, and you will discover opportunities most investors will overlook.