Why is the PE Ratio an essential indicator that investors need to know?

When the stock market experiences a significant decline, many people start looking for opportunities to buy cheap stocks. But the big question is, are the current prices truly cheap or expensive? Should you invest now? And if you do, how long will it take to recover your investment and make a profit?

In reality, opinions on stock prices are subjective. However, in the investment world, there is a standard tool to measure whether a stock is overvalued or undervalued, and that tool is what most Value Investors talk about: PE or PE ratio

What is the PE Ratio? A Simple Calculation Formula

PE ratio stands for “Price per Earning ratio,” which literally means “the ratio between price and profit.” This tool indicates the real meaning: If you buy this stock at the current price, how many years will it take for the company to pay back the amount you invested through its profits?

The formula is very simple:

PE = Price per share ÷ EPS (Earnings Per Share)

Two important variables are:

1. Price per share (Price): The price you pay to buy the stock. The lower the price, the lower the PE, and the faster the return on investment.

2. EPS (Earnings Per Share): The net profit of the company calculated per share. If EPS is high, it means the company is highly profitable. Even if you buy at a high price, the PE might not be as high as you think.

Here’s an example for clarity: Suppose the stock price is 5 baht and EPS is 0.5 baht. The PE will be 10 times, meaning every year, the company pays 0.5 baht in profit. In 10 years, you will have recovered your initial investment (break-even point), and after that, it will be pure profit.

Forward PE vs. Trailing PE: Which is More Reliable?

There is no single PE. In the real market, there are two types that investors need to understand:

Forward PE: Looking Forward

Forward PE uses the current stock price divided by the projected future profit as estimated by analysts. It compares the current value with the expected value in the next year.

The advantage is that it provides a view of future growth, but the limitation is that forecasts are not 100% accurate. Some companies may underestimate profits to beat expectations when announcing results, or foreign analysts may give different figures from the company’s estimates, causing confusion.

Trailing PE: Looking Backward

Trailing PE uses the current price divided by the actual profit generated over the past 12 months. This is the most popular form because it uses real data, not forecasts.

However, Forward PE has its limitations: past performance does not guarantee future results. If a company has just faced a crisis or significant event, Trailing PE may not accurately reflect the current situation.

PE Has Limitations, Yes, But It’s a Useful Tool

The reality is that EPS is not constant over time. It changes based on the company’s growth or negative factors:

Good scenario: Suppose you buy a stock at 5 baht with a PE of 10 times (EPS 0.5 baht). You expect to recover your investment in 10 years. But during that time, the company expands production, exports grow, and EPS increases to 1 baht. When EPS doubles, the PE drops to 5 times. This means you will recover your investment in just 5 years—half the time.

Bad scenario: Conversely, if the company faces trade issues or losses, causing EPS to drop to 0.25 baht, the PE for a 5 baht stock will increase to 20 times. This means you need to wait 20 years to recover your investment.

This is why PE has limitations, but it remains valuable because it helps compare whether stocks are overvalued or undervalued using a common standard. After selecting stocks based on PE, investors should further analyze business fundamentals, growth potential, and risks. This will help reduce errors in decision-making.

Summary: PE Ratio Is a Starting Point, Not the End

Successful investing requires multiple tools. There is no single method suitable for all situations. When the market is volatile, technical analysis tools can help identify trends. But when good opportunities arise where many stocks are reasonably priced, PE ratio is a helpful screening tool.

Understanding what PE is, how to calculate it, and its limitations will enable you to make more rational and accurate investment decisions. Use PE as a tool to identify reasonably priced stocks, then study the company’s quality and future prospects. This approach will help you confidently add good stocks to your portfolio.