How to interpret the PER to select better investments

The P/E ratio is probably the most consulted metric by investors and analysts when deciding whether a company is expensive or cheap. But do we really know how to use it correctly? The reality is that many investors make the mistake of relying solely on this indicator, ignoring that its interpretation depends on multiple factors that go beyond a simple number.

The P/E ratio: definition and role in fundamental analysis

The P/E ratio is a quotient that reflects the relationship between a stock’s market price and the profits the company generates over a given period. The initials stand for Price/Earnings Ratio.

This indicator is positioned as one of the six essential metrics in the fundamental analysis of any company, along with EPS (Earnings Per Share), P/BV (Price to Book Value), EBITDA, ROE (Return on Equity), and ROA (Return on Assets). Essentially, the P/E tells us how many times the company’s annual profit equals its market capitalization. In other words, if a company has a P/E of 15, its current (projected over 12 months) earnings would take 15 years to match the company’s total market value.

Calculating the P/E: two approaches, the same result

There are two ways to obtain this ratio, both leading to the same conclusions. The first involves dividing the company’s total market capitalization by its consolidated net profit. The second, more accessible alternative, is to take the unit price of the stock and divide it by the EPS (earnings per share).

Both formulas require data that are accessible to any investor on specialized platforms. The information is regularly available alongside other parameters such as market capitalization volume, annual price range, or the number of shares outstanding.

In Spanish portals like Infobolsa, the term “PER” is used, while in Anglo-Saxon markets (Yahoo! Finance, Bloomberg), the abbreviation “P/E” predominates. They refer to the same metric under different names.

Practical examples

Suppose a company has a market capitalization of $2.6 billion and annual profits of $658 million. The calculation would be: 2,600 / 658 = P/E of 3.95.

In another scenario, if a stock trades at $2.78 and its EPS is $0.09, we get: 2.78 / 0.09 = P/E of 30.9.

Sectoral interpretation: context is key

A common mistake among investors is comparing the P/E of companies from completely different sectors. Industries have their own dynamics that determine very different valuation ranges.

Banking and industrial companies tend to maintain low ratios. ArcelorMittal, a giant in metallurgy, has a P/E close to 2.58. In contrast, technology and biotech firms operate with significantly higher multiples. Zoom Video Communications, popularized during the remote work era, reached ratios of 202.49.

This contrast reflects market growth expectations: mature sectors with predictable cash flows receive conservative valuations, while innovative sectors with high expansion potential justify higher multiples.

Standard interpretation: valuation frameworks

Generally, analysts use these reference ranges:

Between 0 and 10: suggests an undervalued company, though it may also indicate that profits are at risk of future contraction.

Between 10 and 17: considered the optimal band by most managers, balancing potential growth with realistic earnings expectations.

Between 17 and 25: could indicate an expanding company or signal the beginning of overvaluation.

Above 25: ambiguous territory that represents both opportunities for exceptional growth and potential speculative bubbles.

Advanced variants of the P/E

The Shiller P/E

This variant extends the analysis horizon. Instead of considering a 12-month period, it takes the average of profits over the last 10 years adjusted for inflation. The premise is that a decade of results provides a more robust view than a single year, especially for companies with volatile earnings. The model suggests that this historical data allows for more accurate projections of future behavior.

The normalized P/E

This approach refines the analysis by incorporating balance sheet factors. The numerator is obtained by subtracting liquid assets from market capitalization and adding financial debt. The denominator uses Free Cash Flow instead of pure net profit. This adjustment helps detect situations that traditional P/E hides. The case of Banco Santander buying Banco Popular for one euro exemplifies this: although the nominal price was minimal, assuming multimillion-dollar debt completely changed the real valuation equation.

The real limitations of the P/E

The P/E is a static snapshot, not a dynamic video of the company. It captures a specific moment without reflecting future trajectories or management changes.

It is inapplicable to companies operating without profits. Startups and investment-phase companies present indefinite or negative P/E ratios.

Cyclical businesses generate interpretive distortions. At cycle peaks, the P/E appears low because profits are at their maximum; at cyclical lows, it spikes even though the company remains fundamentally solid.

The indicator only considers historical results to extrapolate future ones, ignoring macroeconomic factors, competitive changes, or technological disruptions.

Real cases: lessons on the complexity of the P/E

Meta Platforms demonstrated how a decreasing P/E does not always correlate positively with the stock price. Between 2020 and late 2022, while the P/E gradually decreased (indicating greater efficiency in profit generation), the stock price collapsed. The reason: Federal Reserve interest rate hikes shifted risk appetite toward less volatile assets.

Boeing exemplifies another pattern. Its P/E remained relatively stable within certain ranges while the stock fluctuated, indicating that the key factor was not the ratio itself but external variables (regulations, product safety, demand outlook).

Strategic combination: P/E and other metrics

An investment based solely on a low P/E will inevitably fail. Many companies on the brink of insolvency maintain low P/E ratios precisely because they lack market credibility.

Value Investing extensively uses the P/E, but never in isolation. Funds like Horos Value Internacional maintain ratios of 7.24 (below the sector average of 14.56) because they combine this criterion with analysis of ROE, ROA, management quality, and dividend sustainability.

A robust fundamental analysis integrates the P/E with Price/Book Value, Return on Equity, Return on Assets, and Return on Tangible Equity. Additionally, it requires examining the composition of profits: do they come from operational business or one-time asset sales? Are they supported by recurring income or non-repetitive events?

Conclusion: a valuable tool, but insufficient on its own

The P/E is useful for quick comparisons between companies in the same sector and geography. It provides an efficient initial filter. However, it should never be the sole decision criterion.

A serious investment strategy requires dedicating time to understanding each company’s core: competitive position, margin trends, management quality, cash flow sustainability. Only then does the P/E act as what it truly is: an informational complement within a broader fundamental analysis ecosystem.