Investors should understand the PE Ratio: A valuation tool for stocks that must be used carefully

When the stock market becomes volatile, many investors want to know whether the stocks they are looking at are cheap or expensive, whether they are worth it or not at the current price. These questions can often be answered using valuation analysis tools that value investors (Value Investor) commonly use, and the most popular one is probably the PE ratio or Price-to-Earnings Ratio. Today, we will delve deeper into understanding this tool.

What is the PE Ratio and Why Is It Important?

The PE ratio or Price per Earning ratio is the ratio between the stock price and earnings per share. This means that if an investor buys a stock, how many years it will take to recover the investment from the company’s profits, assuming the company maintains the same level of profit each year.

A simple way to think about it is: a lower PE ratio indicates that the stock is cheaper and will recover the investment faster, while a higher PE ratio may suggest that the stock is more expensive.

Formula and How to Calculate the PE Ratio

The PE ratio is calculated very simply:

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

This equation involves two components:

1. Stock Price (Price) - the current market price at which investors buy. A lower price results in a lower PE ratio.

2. Earnings Per Share (EPS - Earning Per Share) - calculated by dividing the company’s net profit by the total number of shares. Companies with high EPS often indicate good profitability; even if the stock price is high, the PE ratio might still be low.

Example: If an investor buys a stock at 5 Baht and the stock has an EPS of 0.5 Baht, the PE ratio would be 10 times, meaning the investor would need 10 years to recover the investment (if the company maintains the same profit level).

The Difference Between Forward P/E and Trailing P/E

There are two different ways to calculate the PE ratio:

Forward P/E (P/E Forward)

Forward P/E uses the current stock price divided by the projected future earnings of the company. This helps investors see the growth potential in the future without relying on past data.

Advantages: Shows the company’s growth potential. Limitations: The company might underestimate future earnings to keep the PE ratio low, or external analysts’ estimates may be inaccurate.

Trailing P/E (P/E Past)

Trailing P/E uses the current stock price divided by the actual earnings over the past 12 months. This method is popular because it uses real data and is quick to calculate. Many investors prefer Trailing P/E because it does not depend on others’ estimates.

Advantages: Uses real data, highly reliable. Limitations: Past performance does not necessarily indicate future results.

Limitations Investors Should Know About the PE Ratio

Although the PE ratio is a useful tool, it has limitations that should be considered:

EPS can change: EPS is not constant over time. If the company experiences major events or new factors, the PE ratio will also change.

Positive example: A company bought at a PE ratio of 10 times (price 5 Baht, EPS 0.5 Baht) might expand production and exports, causing EPS to rise to 1 Baht. The PE ratio then drops to 5 times, meaning the break-even point is now 5 years instead of 10.

Negative example: Conversely, if the company faces problems such as trade losses or legal settlements, causing EPS to fall to 0.25 Baht, the PE ratio will rise to 20 times, meaning investors will need 20 years to recover their investment.

The PE ratio does not tell the whole story: It should not be used alone to make investment decisions. Other factors such as industry outlook, management quality, and overall financial health should also be considered.

How to Use the PE Ratio Effectively

The PE ratio is useful for comparing different stocks in the market using a common standard. When identifying stocks with low PE ratios, investors should conduct further research to understand why the PE ratio is low—perhaps due to market loss of confidence or unjustified undervaluation.

Summary

The PE ratio is another tool that helps investors evaluate stock value systematically. However, it is not suitable for all situations. When markets are volatile, technical analysis tools can also be helpful. But when selecting good stocks for a portfolio, combining the PE ratio with other tools can lead to more accurate decision-making. By integrating various methods and understanding each tool’s limitations, investors can time their investments wisely and consistently add quality stocks to their portfolios.