When stocks fluctuate and come down, what tool should be used to measure the price? PE Ratio, the answer investors are looking for

The stock market downturn is a period of opportunity, but it also creates confusion for many investors. Stock prices have fallen, but it’s still uncertain whether the current price level is a good entry point or not, because there is no standard tool to measure whether prices are overvalued or undervalued. There are several standard methods for this assessment, but the most trusted and widely discussed indicator among value-focused investors (Value Investor) is the PE ratio, or full name Price per Earning ratio. This article will discuss what the PE ratio is and how we can utilize it effectively.

PE Ratio: The Main Indicator for Value Investors

The PE ratio, or Price per Earning ratio, translates from Thai as the ratio of price to earnings. It indicates how many years an investor must wait for the company’s profits to recover the initial investment cost of buying the stock.

In other words, if the company earns profits at the current level each year, it would take a PE ratio number of years to break even on the investment.

How to Calculate PE Ratio and Its Components

PE ratio = Price (per share) ÷ EPS (Earnings Per Share)

This formula involves two key factors:

1. Price per share (Price)
The stock price paid by investors. The lower the purchase price, the lower the PE ratio, and the quicker the investment is recovered.

2. Earnings Per Share (EPS - Earning Per Share)
The net profit value of the company per year, averaged across all shares. It shows how much return each shareholder receives. A high EPS indicates strong profitability. If the PE ratio is low, it suggests a faster return on investment.

The golden rule of PE Ratio: The lower, the better because a low PE indicates that the stock price is undervalued or that the company has high profitability, resulting in a shorter payback period.

Example Calculation of PE Ratio

Suppose an investor buys a stock at 5 baht per share, and the company’s EPS is 0.5 baht.

PE Ratio = 5 ÷ 0.5 = 10 times

Meaning: The company generates a return of 0.5 baht per year per share. It would take 10 years for the investor to recover the initial 5 baht investment. From the 11th year onward, all profits are pure gains without additional costs.

Forward P/E and Trailing P/E: How to Choose?

Investors often encounter two types of PE ratios: Forward P/E and Trailing P/E.

Forward P/E: Looking Forward

Forward P/E uses the current stock price divided by projected future earnings (generally in the next year). It helps investors visualize the company’s growth prospects without waiting for historical data.

Advantages:
Provides insight into the company’s growth potential. Suitable for analyzing growing companies.

Limitations:
Relies on forecasts that may be inaccurate. Sometimes, the stock price may be undervalued relative to future earnings, or analysts’ estimates may vary.

Trailing P/E: Looking Backward

Trailing P/E uses the current stock price divided by actual earnings over the past 12 months. It is the most popular method among investors because it is based on actual, realized data.

Advantages:
Data is certain and quick to compute. Investors do not need to rely on estimates from others.

Limitations:
Historical data may not reflect current conditions. If the stock price drops after the annual report, the PE ratio will change, potentially leading to misjudgment.

Limitations Investors Should Be Aware Of

Although the PE ratio is a useful tool, it has limitations:

Changing Factors
Suppose an investor buys a stock at 5 baht with a PE of 10, expecting to hold for 10 years. During this period, EPS may change:

• Positive scenario: The company expands production and exports, increasing EPS to 1 baht, reducing PE to 5, and shortening the payback period to 5 years.

• Negative scenario: The company faces issues like trade barriers, reducing profits to 0.25 baht, causing PE to rise to 20, and extending the holding period to 20 years.

Therefore, PE ratio should be used as a preliminary guide, not the sole decision factor.

How to Use the PE Ratio Effectively?

The PE ratio is valuable because it enables comparison of valuation levels across different stocks using a common standard. After selecting stocks with reasonable PE ratios, investors can further study other limitations and factors influencing returns.

Conclusion

Investors aiming for success in the stock market do not need to rely on a single tool. During uncertain market conditions, combining various techniques can be beneficial. However, when the opportunity arises to identify good stocks for the portfolio, a PE ratio that is appropriate provides a helpful measure to buy undervalued stocks confidently and build a solid portfolio. The PE ratio is therefore an essential indicator that investors should not overlook. By understanding and properly applying the PE ratio, investment decisions can become more precise.