Investors Need to Know About PE Ratio: A Tool to Understand Stock Prices

When you look back after a market correction, many people focus on the stocks they are interested in but wonder whether the current price level is cheap or expensive. The follow-up questions are: Should I buy now? When will I break even? When will profits come?

To find the answers, value investors (Value Investors) often refer to several indicators, but the most frequently discussed is the PE Ratio, which stands for Price-to-Earnings Ratio. This article will help you understand what the PE Ratio is and how to use it.

PE Ratio: A Definition You Should Know

PE stands for Price-to-Earnings Ratio. This metric indicates if you buy a stock at this price, how many years it will take to recover your investment, assuming the company generates the same profit every year.

In other words, the PE Ratio helps you understand how much you are paying for each dollar of profit the company makes.

How to Calculate the PE Ratio?

The basic formula is:

PE Ratio = Stock Price ÷ EPS (Earnings Per Share)

This formula has two components:

1. Stock Price (Price): This is the current market price. The lower the purchase price, the lower the PE Ratio, and the sooner you reach the breakeven point.

2. Earnings Per Share (EPS): This is calculated by dividing the company’s net profit by the total number of shares outstanding. It indicates how much profit each shareholder receives per year. A high EPS shows the company’s strong profit-generating ability.

Example Calculation:
Suppose you buy a stock at 10 THB per share, and the EPS at that time is 1 THB.
PE Ratio = 10 ÷ 1 = 10 times

This means you need to wait until the company generates enough profit to give you back 10 years’ worth of earnings to recover your initial investment.

The Difference: Forward P/E vs. Trailing P/E

There are two types of PE ratios that investors often discuss:

Forward P/E (Future P/E)

Forward P/E uses the current price divided by projected future earnings, usually for the next year.

Advantages: It helps you see the true value of the company in the future without waiting for actual figures.

Disadvantages: It relies on estimates, which may not always be accurate. Some companies might underestimate future profits to make the Forward P/E look more attractive when actual results are announced.

( Trailing P/E )Past P/E###

Trailing P/E uses the current price divided by actual earnings over the past 12 months.

Advantages: This figure is based on real data, not estimates, making it more reliable.

Disadvantages: Past performance does not guarantee future results. If the company experiences significant changes that affect profitability, Trailing P/E may reflect this only with a delay.

Limitations Investors Should Be Aware Of

Although the PE Ratio is a useful tool, it has its drawbacks:

1. EPS is not constant: When circumstances change, EPS can increase or decrease. For example, if a company expands its market and EPS rises from 0.5 THB to 1 THB, a stock priced at 5 THB would have its PE ratio drop from 10 to 5. This means the breakeven period shortens from 10 years to 5 years.

2. Negative factors may occur: Conversely, if EPS drops from 0.5 THB to 0.25 THB, the PE ratio will rise from 10 to 20. Investors would then need to wait 20 years to break even.

3. It’s not the only tool: The PE Ratio does not reflect management quality, debt levels, or long-term growth opportunities.

In Conclusion

A lower PE Ratio generally indicates a cheaper stock. Successful investors do not rely on a single metric. In volatile markets, combining PE Ratio with other indicators can help inform better decisions. Once you understand that PE stands for Price-to-Earnings Ratio and know how to use it, you will be able to evaluate stocks more wisely and time your investments more effectively.