Investment Essentials: A Complete Guide to EPS and Price-to-Earnings Ratio to Help You Understand Stock Valuations

Many investors often hear investment advisors or analysts discuss, “This stock is very cheap now, with a P/E ratio of only 13 times,” when buying or selling stocks. But do you truly understand what the P/E ratio is telling you?

In simple terms, the Price-to-Earnings (P/E or PER) reflects how many years it would take for a company to recoup its investment through earnings. It is the most core indicator for judging whether a stock is expensive or cheap. Meanwhile, Earnings Per Share (EPS) is the fundamental data used to calculate the P/E ratio. Mastering these two indicators will make your investment decisions much clearer.

Understanding the Relationship Between P/E Ratio and EPS Through the TSMC Case

Taking TSMC as an example, suppose the current stock price is NT$520, and the full-year EPS for 2022 is NT$39.2. Then, the P/E ratio = 520 ÷ 39.2 ≈ 13.3 times.

What does this number represent? If you buy TSMC stock now, theoretically, it would take 13.3 years to recover your investment through the company’s earnings. The lower the P/E ratio, the cheaper the stock price relative to earnings; the higher the P/E, the higher the market’s valuation of the company.

The Three Methods to Calculate P/E Ratio You Need to Know

The key question is: Why does the P/E ratio of the same stock change? It depends on which period’s EPS you use for calculation.

Static P/E Ratio: Using the EPS of the past year

The static P/E ratio uses the latest complete year’s EPS. Formula: P/E = Stock Price ÷ Annual EPS

For TSMC, the 2022 EPS is calculated as: Q1 (7.82) + Q2 (9.14) + Q3 (10.83) + Q4 (11.41) = NT$39.2.

Since the annual EPS does not change before the new annual report is released, this P/E fluctuation is entirely due to stock price changes, hence called “static.” Its advantage is that the data is confirmed; its drawback is that it reflects past performance and may lag behind future prospects.

Rolling P/E Ratio (TTM): Using the EPS of the most recent four quarters

If you want a more timely valuation reference, you can use Rolling P/E (TTM) = Stock Price ÷ Sum of EPS of the latest four quarters.

Suppose the EPS for Q1 2023 is NT$5. Then, the total EPS for the latest four quarters is: Q2 22 (9.14) + Q3 22 (10.83) + Q4 22 (11.41) + Q1 23 (5) = NT$36.38. At this point, the rolling P/E = 520 ÷ 36.38 ≈ 14.3 times.

Compared to the static P/E of 13.3 times, the rolling P/E reflects the latest earnings changes, overcoming lag. However, this method also has drawbacks: it still relies on past data and cannot predict future profits.

Dynamic P/E Ratio: Using estimated EPS

The third approach is to use analyst estimates of EPS. Formula: P/E = Stock Price ÷ Estimated Annual EPS

If analysts estimate TSMC’s 2023 EPS to be NT$35, then the dynamic P/E = 520 ÷ 35 ≈ 14.9 times.

The advantage of the dynamic P/E is that it reflects market expectations for the future. But the problem is: different institutions’ estimates vary greatly, and forecasts are often inaccurate, which can mislead investors. Therefore, although the concept is attractive, its practical usefulness is the lowest.

How to Judge Reasonable P/E Ratios? Using These Two Methods

Looking at a P/E number alone, you cannot determine if it is high or low. You must compare it to other data to draw conclusions.

Method 1: Horizontal comparison with peers

P/E ratios vary greatly across industries. According to data from Taiwan Stock Exchange in 2023, the automotive industry has a P/E as high as 98.3 times, while the shipping industry is only 1.8 times. Clearly, they cannot be directly compared.

When investing, choose companies with similar businesses for benchmarking. For example, TSMC (PE about 23.85 times) can be compared with UMC (PE about 15 times), and Taiwan Advanced Semiconductor (台亞) among peers. From this perspective, TSMC’s P/E is relatively high, but this may reflect its industry-leading position and better profitability.

Method 2: Vertical comparison with its own historical P/E

Another way is to look at the company’s historical P/E trend. Currently, TSMC’s P/E is in the “upper-middle range” of its five-year history—not at bubble highs, but clearly above recession lows, showing a healthy rebound after economic and market expectations improved.

This comparison tells you where the current valuation stands relative to its own history, helping you assess whether there is an undervaluation opportunity.

P/E River Chart: Visualizing Stock Price Highs and Lows

There is also a more intuitive tool called the P/E River Chart. It plots 5 to 6 lines on the stock price chart, each calculated as: Stock Price = EPS × P/E ratio.

• The top line uses the historical highest P/E ratio, representing the highest estimated stock price.
• The bottom line uses the historical lowest P/E ratio, representing the lowest estimated stock price.
• The middle lines represent various reasonable price zones.

For example, if TSMC’s stock price is between the two lower lines (say, at 13x and 14.8x P/E), it indicates the current price is relatively undervalued. This is often seen as a good entry point. But remember: Undervalued does not necessarily mean it will rise, as stock prices are influenced by many factors.

What Are the Limitations of P/E Ratio? What Should Investors Be Aware Of?

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

1. Ignoring corporate debt

The P/E ratio only reflects equity value and does not consider a company’s liabilities. Two companies with the same P/E may have very different risks if one relies on self-funded profits and the other on borrowing. During economic fluctuations or interest rate changes, the latter’s risk resilience is worse. So, you cannot simply judge that the company with a higher P/E is “more expensive” or “more risky.”

2. Difficulty in defining what constitutes a high P/E

A high P/E can have multiple interpretations: it might mean the company is temporarily facing headwinds with declining profits but stable fundamentals; it could also indicate the market’s optimism about future growth, leading to early valuation; or it might be a bubble correction. In different situations, a high P/E means very different things, making it impossible to judge solely based on historical experience.

3. Cannot evaluate unprofitable companies

Many startups or biotech firms have not yet achieved profitability and thus cannot be assigned a P/E ratio. In such cases, other valuation metrics are needed.

PE, PB, PS: The Differences and Applications of the Three Major Valuation Indicators

When P/E is not suitable or a multi-dimensional assessment is needed, investors can refer to other indicators:

EPS is the core data for calculating P/E, but it should not be viewed in isolation. Combining it with growth prospects, industry position, and financial health will lead to more rational investment decisions.

Mastering the relationship between P/E and EPS, understanding the three calculation methods, and combining peer comparison with historical trends will help you build a relatively complete valuation framework. When investing in stocks or other assets, these tools will help you avoid blind buying or selling and identify more valuable investment opportunities.