P/E is the key to smart stock valuation.

During market downturns, many investors feel frustrated because they don’t know if the current stock prices are fair or not. They want to know whether to accumulate now or not, and most importantly, when they will break even and start making a profit. Answering these questions isn’t as mysterious as it seems because there is a valuation tool that very few investors use: the P/E ratio. It indicates whether a stock’s price is reasonable and how long it will take to recover the invested capital.

Why the P/E Ratio Is a Must-Know Tool for Investors

When you decide to buy a stock, the first question is “Is this price fair or expensive?” Usually, the answer depends on personal judgment. But in investing, there is a standard method called P/E ratio, which shows the ratio between the stock price and the company’s earnings. Simply put, if you buy a stock at the current price, how many years of the company’s profits do you need to accumulate to break even?

This is why high-level value investors often focus on the P/E ratio. However, many misunderstand it as complicated, when in fact, it’s quite simple.

The P/E Formula Is Easier Than You Think

The fact that the P/E ratio is based on a very simple formula is surprising: P/E = Stock Price ÷ Earnings Per Share (EPS).

There are only two variables:

First Variable: Current Stock Price (Price)
This is the price you pay to buy the stock. The lower the purchase price, the lower the P/E ratio, and the faster you’ll break even.

Second Variable: Earnings Per Share (EPS)
This is the company’s net profit divided by the total number of shares outstanding. In simple terms, “profit per share annually.”

A key technique: If you find stocks with high EPS (meaning the company is highly profitable), even if the stock price looks high, the P/E ratio might still be low because high EPS reduces the ratio. This means you can recover your investment faster.

The lower the P/E ratio, the cheaper the stock, and the quicker you can recoup your investment.

For example: Suppose you buy a stock at 5 baht, and the company’s EPS is 0.5 baht. The P/E ratio is 10 (5 ÷ 0.5). This means the company returns 0.5 baht annually, and it will take 10 years to recover your investment. After 10 years, all profits are yours.

Forward P/E and Trailing P/E — Which One Is Better?

In real markets, there are two types of P/E ratios investors should know:

Forward P/E

Forward P/E uses the current stock price divided by the “expected future earnings.” This helps you see “if the company performs as planned, what will the profits look like.”

Advantages: It allows you to estimate the company’s growth potential.
Disadvantages: It relies on estimates from others, which may be overly conservative or optimistic. Companies might understate future earnings to make the forward P/E look more attractive, and analysts’ forecasts can vary widely, causing confusion.

Trailing P/E

Trailing P/E uses past data, dividing the current stock price by the earnings over the last 12 months. This is the most common and trusted method because it’s based on actual results, not estimates, and is easy to calculate.

However, the limitation is that “the past doesn’t always predict the future.” If a company has recently undergone significant changes, trailing P/E might not reflect its current situation.

Limitations of the P/E Ratio That Investors Must Recognize

Although the P/E ratio is a useful tool, it’s not infallible. The P/E can change rapidly because EPS is never constant.

For example: You buy a stock at 5 baht with EPS of 0.5 baht, giving a P/E of 10. Suppose the company expands into new markets, and EPS rises to 1 baht. The P/E drops to 5, meaning you can now break even in 5 years instead of 10.
Conversely, if the company faces problems and EPS drops to 0.25 baht, the P/E doubles to 20, and it would take 20 years to recover your investment.

This illustrates why P/E should be used alongside other tools and not relied upon solely.

How to Use the P/E Ratio in Actual Investment Decisions

Despite its limitations, the P/E ratio remains a valuable benchmark for comparing stocks across the market because it provides a “standardized measure” for all stocks.

The key point: After selecting stocks with low P/E ratios, you should investigate further: “Why is this company’s EPS high or low?” “Does it have growth prospects?” “Are there other risks?” This step helps avoid buying stocks that seem cheap but are actually “cheap for a reason.”

Use the P/E ratio as a screening tool, but also understand the company and industry fundamentals. Never invest blindly just because the P/E ratio is low.

Summary: The P/E Ratio Is a Tool You Must Know, But Use Wisely

For serious investors aiming for success, understanding what the P/E ratio is and how to use it is fundamental. Combining this tool with others like PBV, ROE, or profit analysis will give you greater confidence in selecting good stocks.

Ultimately, the P/E ratio is not the final answer but a good starting point for making informed investment decisions and achieving long-term profits.