Why do investors need to understand the PE Ratio? A guide to buying stocks at a cheap price for your portfolio

When the market declines and stocks become cheaper, many investors may face the same questions: “Is the current price truly cheap?” “If I buy now, when will I break even?” “Will I make a profit quickly, slowly, or miss the opportunity?” These questions cannot be answered solely by feelings or experience.

In a disciplined investment approach, there are several tools to measure whether a stock is overvalued or undervalued. But the most favored tool among Value Investors or those focusing on intrinsic value is the PE ratio or Price-to-Earnings Ratio. This article will explain what the PE ratio is, how to use it to assess whether a stock is cheap or expensive, and what to watch out for.

What is the PE Ratio? Understand it from its name first

PE ratio stands for Price per Earning ratio, where Price means the stock price, and Earning means the company’s profit. So, the name indicates that the PE ratio is the ratio between the price you pay and the profit the company generates for you each year.

A deeper analysis shows that the PE ratio tells you: “If you buy the stock at this price and the company makes the same profit every year, how many years do you need to hold the stock to recover your initial investment (break even).”

It essentially answers the question every investor cares about: “Is buying this stock worth it?”

How the PE Ratio is calculated: the behind-the-scenes of the number

Basic formula

The PE ratio is very easy to calculate:

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

This formula involves only two variables, but each has a significant meaning:

Variable 1: Stock Price (Price)

The stock price is the market price on the day you buy (or the analysis date). The lower the purchase price, the lower the PE ratio, which means you will recover your investment faster.

Variable 2: Earnings Per Share (EPS - Earnings Per Share)

EPS is calculated from the company’s net profit divided by the total number of shares outstanding, indicating the profit each shareholder receives per share per year.

A company with high EPS demonstrates strong profit-generating ability. Therefore, even if you buy at a higher PE ratio, it might turn out to be low because the denominator (EPS) is large.

Simple example

Suppose you buy a stock:

• Price: 5 Baht per share
• Current EPS: 0.5 Baht

PE Ratio = 5 ÷ 0.5 = 10 times

This means: You need to hold the stock for 10 years, with the company paying 0.5 Baht annually. The total will be 5 Baht, exactly equal to your initial investment. After the 10th year, all returns are pure profit.

A simple rule: The lower the PE ratio, the cheaper you buy the stock, and the faster you recover your investment.

Forward P/E vs. Trailing P/E: past and future

Investors need to understand that the PE ratio has two versions, calculated differently and with different meanings:

Forward P/E: “Expected future earnings”

Forward P/E uses the current stock price divided by the expected earnings the company will generate in the next year (or analyst forecasts).

Advantages:

• Helps investors look ahead and assess growth potential
• Suitable for companies in recovery phases

Disadvantages:

• Based on forecasts, which may be inaccurate
• Some companies might underestimate future earnings to appear cheaper
• Different analysts may have varying opinions

Trailing P/E: “Actual past performance”

Trailing P/E uses the current stock price divided by the total earnings over the past 12 months. This is actual historical data.

Advantages:

• Uses real data, not guesses
• Quick calculation with publicly available info
• Lower risk compared to Forward P/E

Disadvantages:

• Past performance does not guarantee future results
• Does not reflect new growth opportunities
• May be less suitable for rapidly changing companies

Limitations investors should be aware of

The PE ratio is a useful tool but not a complete financial statement. Its main limitations include:

1. EPS is not constant

Suppose you buy a stock at PE = 10, planning to hold for 10 years, but unexpected events can happen:

Positive scenario: The company expands its factory or exports more, increasing profit from EPS 0.5 Baht to 1 Baht. The PE ratio drops to 5. Now, you can recover your investment in just 5 years instead of 10.

Negative scenario: The company faces trade wars or large damages, reducing profit from 0.5 Baht to 0.25 Baht. The PE ratio rises to 20. Now, you need to hold for 20 years to break even!

2. The PE Ratio is not the only indicator

Two companies with the same PE ratio can have vastly different qualities. You should also study:

• Financial health (Debt, Cash Flow)
• Asset quality
• Management team
• Industry characteristics

3. Compare within the same industry only

Tech companies often have higher PE ratios than utilities because of different growth rates. Comparing across industries can lead to incorrect conclusions.

Why does the PE Ratio still remain a valuable tool?

Despite its limitations, the PE ratio remains popular because:

• Standardized comparison: It allows comparing multiple stocks within the same market in a consistent way
• Time-saving: No need to analyze all financial statements
• Easy to understand: General investors can calculate it themselves

In short, the PE ratio is a good starting point, not the end of analysis.

Summary: PE Ratio is just part of the game

Successful investors do not rely on a single tool. Different situations call for different approaches:

• When markets are volatile, use analysis techniques to find opportunities
• When markets are stable, it’s the best time to select quality stocks for your portfolio

When looking for buy points, use PE ratio as a guide to see if the current price is favorable, but also consider other factors such as profit growth, industry trends, and company quality.

If investors understand how to use the PE ratio correctly and are aware of its limitations, you can buy stocks at cheap prices and build your portfolio confidently, increasing your chances of thriving in the stock market.