How to calculate whether a stock is overvalued or undervalued? Understand the PE ratio deeply

When the market drops significantly, investors start asking, “Is the current price right?” “Should I buy now?” “If I buy now, how quickly can I make a profit?” These questions can be answered by using a metric called PE ratio, which is a tool most Value Investors use to measure whether a stock is cheap or expensive.

What exactly is the PE ratio?

PE ratio stands for Price per Earning ratio or the ratio of a stock’s price to its earnings per share. This indicator tells us that if we buy this stock at the current price, how many years it will take for the company to generate enough profit to recover our investment.

It’s like asking, “How long do I have to wait to break even?” A low PE means you can break even faster, while a high PE indicates you’ll need to wait longer.

The formula for calculating the PE ratio is simple

PE = Stock Price ÷ Earnings Per Share (EPS)

Key factors include:

1. Stock Price (Price) - The price at which we buy the stock in the market. The lower the price, the lower the PE will be.

2. Earnings Per Share (EPS - Earning Per Share) - Calculated from the company’s net profit for the year divided by the total number of shares. A high EPS indicates a company with strong profitability.

The higher the company’s EPS, the lower the PE ratio, which means even if we pay more than usual, we can still recover our investment quickly because the company is highly profitable.

Example for better understanding

Suppose we buy a stock at 5 baht per share, and the company has an EPS of 0.5 baht. The PE ratio would be 10 (5 ÷ 0.5 = 10)

This means:

• The company pays a profit of 0.5 baht per share each year.
• It takes 10 years to accumulate enough profit to recover the 5 baht investment (0.5 × 10)
• After 10 years, all profits are considered net income.

Forward P/E vs. Trailing P/E: What’s the difference?

PE has two common formats used by investors:

Forward P/E (Forward-looking estimate)

Uses the current stock price divided by the expected EPS in the future. This helps us see whether “if the company grows as planned, is the current price fair or expensive?”

Advantages: Looks ahead, reflects growth potential.

Disadvantages: Relies on forecasts that may be inaccurate. Companies might underestimate profits to meet targets easily, or analysts inside and outside the company might give different estimates, causing confusion.

Trailing P/E (Historical data)

Uses the current stock price divided by the actual EPS over the past 12 months. This is the most popular method because it uses real data.

Advantages: Uses actual data, quick to calculate, many investors prefer it because it doesn’t rely on forecasts.

Disadvantages: Past performance doesn’t guarantee future results. If recent significant events have changed the company’s situation, Trailing P/E won’t reflect those changes immediately.

Limitations to be aware of

PE ratio is not a perfect tool because:

1. EPS can change constantly - Company profits are not static. If a company grows faster than expected, EPS can spike. For example: if a company expands its product lines or exports markets, EPS might increase from 0.5 to 1 baht per share, reducing the PE from 10 to 5. This means the break-even point shortens from 10 years to 5 years.

2. Negative factors can have a severe impact - Conversely, if the company faces issues like trade restrictions or legal damages, EPS might fall from 0.5 to 0.25 baht per share, causing the PE to rise from 10 to 20. The break-even point then extends to 20 years.

3. Cannot be used in isolation - A good PE ratio should be combined with other tools, such as industry trends, competitive advantages, or debt structure, to get a more accurate picture.

How to use the PE ratio effectively

Successful investors are not those with only one tool but those who know when to use which. The PE ratio is a helpful tool for selecting stocks that seem reasonably priced but must be used with caution:

• A low PE ≠ always cheap (there may be underlying reasons)
• Use Forward P/E to understand growth potential
• Combine with Trailing P/E to review historical performance
• Be aware of its limitations before making investment decisions

By understanding the PE ratio deeply, you can better time your entry into stocks and avoid undervalued stocks with underlying problems.