PE Ratio is: a way for investors to measure stock value that they need to understand

When the stock market prices decline, many investors start looking for opportunities to buy undervalued stocks. But the big question that causes hesitation is: Are the current prices truly accurate? Is it the right time to buy? And when will profits be realized? These questions lead us to a tool that professional investors, or what is called Value Investors, often use: the PE Ratio, which is a metric that helps us see the value of a stock more clearly.

Understanding the PE Ratio - Price-to-Earnings Ratio

PE Ratio stands for “Price per Earning Ratio,” a number that tells us how many years it would take to recover our investment from the company’s profits if we buy the stock at this price, assuming the company’s profits remain constant.

For example, if you buy a stock at 50 baht and the company has an earnings per share (EPS) of 5 baht per year, the PE Ratio would be 10. This means you need to wait 10 years to recover your initial investment, after which all profits flow directly to the investor.

Therefore, the PE Ratio is a useful tool to compare which stocks are better and cheaper than others in the market. A lower PE indicates a more reasonable stock price and a faster capital recovery.

How to Calculate the PE Ratio in Detail

The basic formula for the PE Ratio is straightforward: PE = Stock Price ÷ EPS

Both variables are important and must be understood thoroughly:

Stock Price is the amount an investor pays for one share. The lower the purchase price, the lower the PE ratio, which is a positive sign indicating we are getting a good deal at a cheap price.

Earnings Per Share (EPS) is the company’s net profit divided by the total number of shares. It reflects the return each shareholder receives in a year. A high EPS indicates the company is efficient at generating profits.

In real scenarios, an interesting situation is when investors buy stocks of companies with high EPS, even if the stock price is relatively high. The resulting PE might not be high because the denominator (EPS) is large, meaning the company is earning well, and the payback period is shorter.

Consider this example: an investor buys a stock at 100 baht, and the company’s EPS is 10 baht, resulting in a PE of 10. This means it would take 10 years to recover the investment. If the EPS increases to 20 baht, even if the stock price remains the same, the PE drops to 5, halving the payback period.

Forward P/E vs. Trailing P/E

In investing, PE is also divided into two types based on the data used:

Forward P/E (also called projected P/E) uses the current stock price divided by the “expected future earnings,” often estimated for the next year or upcoming fiscal period. The advantage is that it provides a view of potential future profits if the company grows as planned. However, the limitation is that these estimates are uncertain; companies or analysts might overestimate or underestimate future earnings to impress investors later.

Trailing P/E uses actual earnings from the past 12 months divided by the current stock price. This method is most popular because it is based on real, realized figures, not forecasts. Investors don’t need to worry about over- or under-estimation.

However, Trailing P/E has drawbacks: if the company undergoes significant changes or special events, past data may not reflect future performance. It’s best to use both types of PE together for a balanced view.

Limitations of Using the PE Ratio to Evaluate Stocks

Although the PE Ratio is a powerful and widely used tool, it is not a perfect measure.

One major issue is that a stock’s EPS is not always constant. For example, if you buy a stock at 50 baht with an EPS of 5 baht, the PE is 10. You might think you need 10 years to break even. But if the company expands significantly, enters new markets, or improves efficiency, EPS could rise to 10 baht per year, reducing the PE to 5. The break-even point then shortens to 5 years.

Conversely, if the company faces problems—such as trade restrictions or fierce competition—EPS might fall to 2.5 baht, causing the PE to rise to 20. This means you might need 20 years to recover your investment or risk losing money from the start.

Additionally, the PE Ratio does not tell us about the quality of the business, financial stability, or debt-paying ability. These aspects require further analysis using other indicators like Debt-to-Equity Ratio or Free Cash Flow.

Applying the PE Ratio in Real Investment Decisions

Despite its limitations, the PE Ratio remains widely used because it provides a standardized way to compare multiple stocks fairly.

The key is not to rely solely on PE for decision-making. Investors should view stocks from a 360-degree perspective: analyze EPS trends, industry competition, company news, and compare the PE ratio to the market average or competitors’ PE.

After an initial assessment based on PE, investors should also study other metrics such as ROE (Return on Equity), PEG Ratio, or fundamental analysis of the company to reduce risks and improve chances of success.

PE Ratio is a tool that helps investors gauge the value of a stock at a glance. But remember, successful investing often requires education, analysis, and managing various risks. PE Ratio is just the beginning; building a strong portfolio involves many other tools and knowledge.