Understanding the PER: The Metric Every Investor Needs to Master

Why the P/E Ratio is the Fundamental Indicator You Cannot Ignore

When analyzing companies for investment, there is one metric that stands out above all others: the P/E ratio. Along with EPS (Earnings Per Share), these are two tools that form the foundation of fundamental analysis. Its importance lies not only in comparing companies but also in helping us understand a company’s growth and valuation over the years.

The P/E ratio shows us how many times the company’s annual earnings are reflected in its market price. In other words, it indicates the number of years it would take for the current projected earnings (projected over 12 months) to fully pay for the company’s market value.

Deciphering What the P/E Ratio Really Is

The acronym P/E stands for Price/Earnings Ratio. Essentially, this metric establishes a direct relationship between two magnitudes: the price the market pays for a share and the earnings the company generates periodically.

Among the six essential ratios to evaluate a company’s health are:

1. The P/E ratio
2. The EPS
3. The P/BV (Price/Book Value)
4. The EBITDA
5. The ROE
6. The ROA

What sets the P/E ratio apart is its ability to quickly show whether we are facing an investment opportunity or a possible overvaluation. For example, a P/E of 15 means that the company’s market capitalization equals 15 times its annual earnings.

How the P/E Works in Practice: Real Cases

The relationship between the P/E ratio and a stock’s price is not always linear. Consider the case of Meta Platforms (formerly Facebook): for years, while the P/E consistently decreased, the stock price rose. This reflected the sustained earnings growth of the company. However, at the end of 2022, this relationship broke down: despite the P/E continuing to fall, the stock price declined due to external factors, such as the FED’s monetary policy decisions that penalized tech companies.

Another example is Boeing, where the P/E remained relatively stable within a range, while the price fluctuated significantly. This behavior indicates that other market factors influence the stock as much as earnings do.

Calculating the P/E: Two Paths to the Same Result

There are two equivalent ways to calculate the P/E, both providing the same result:

First formula (using global magnitudes): P/E = Market Capitalization / Net Earnings

Second formula (using per-share data): P/E = Share Price / Earnings Per Share (EPS)

Let’s look at two practical examples:

Example 1: A company with a market capitalization of $2.6 billion and net earnings of $658 million would have a P/E of 3.95.

Example 2: A company with a share price of $2.78 and EPS of $0.09 would have a P/E of 30.9.

Both calculations are straightforward, as this information is publicly available on any financial platform.

Where to Find the P/E and How It Is Presented

The P/E appears in virtually any financial source providing asset data. Depending on the region, it may be found under the initials “P/E” (more common in Spain and Europe) or “P/E” (the predominant nomenclature in the United States and the UK).

In Spanish platforms like Infobolsa, it appears as “P/E,” while in U.S. sites like Yahoo! Finance, “P/E” is used. Additional information includes market capitalization, EPS, 52-week range, and shares outstanding.

Shiller P/E vs. Traditional P/E: Which Is Better?

There is a variant known as the Shiller P/E that deserves special attention. The main difference lies in the analysis horizon.

The conventional P/E uses earnings from a single year, which can be misleading due to annual result volatility. The Shiller P/E, on the other hand, takes a 10-year period, calculating the average earnings adjusted for inflation:

Shiller P/E = Market Capitalization / Average Earnings of the Last 10 Years (adjusted for inflation)

The theory behind this approach suggests that a 10-year period allows for a more accurate projection of earnings over the next 20 years.

The Normalized P/E: A Deeper Analysis

Another variant is the normalized P/E, which offers a more accurate view of the company’s true financial health. Instead of using net earnings, it uses Free Cash Flow in the denominator, and the numerator includes market capitalization minus liquid assets plus financial debt.

This approach is especially useful in complex cases. An emblematic example is the acquisition of Banco Popular by Banco Santander for 1 euro: although it appeared to be a symbolic purchase, the assumption of colossal debt was decisive in the final decision.

Interpreting the P/E: When Is a Company Expensive or Cheap?

The traditional interpretation of the P/E suggests:

• Between 0 and 10: Low P/E, attractive but with potential risk of future earnings decline
• Between 10 and 17: Optimal range according to analysts, indicating moderate growth without excessive expectations
• Between 17 and 25: Possible overvaluation or recent significant growth
• Over 25: Signal of very positive expectations or a speculative bubble

However, this interpretation is not absolute. The market can sustain prolonged undervaluations if management is poor. Historically, many companies with seemingly attractive P/E ratios have gone bankrupt, demonstrating that the indicator only works as a complementary tool.

Sector Differences Every Investor Must Know

A critical aspect often overlooked: the P/E varies significantly by sector. Banking and industrial companies typically have low P/E ratios, while tech and biotech firms maintain high ratios.

ArcelorMittal, involved in metallurgy, operates with a P/E of 2.58. Zoom Video, in the tech sector, had ratios exceeding 200. This difference does not mean one is better than the other but reflects different sector dynamics. Comparing companies from different sectors using only the P/E is methodologically incorrect.

The P/E and Value Investing Strategy

Value investors look for good companies at a good price. For them, the P/E is a fundamental tool. Specialized funds like Horos Value Internacional maintain a P/E of 7.24, significantly below the average of its category (14.56). Similarly, Cobas Internacional has a P/E of 5.47, demonstrating how value managers track assets that the market has temporarily undervalued.

Why the P/E Should Not Be Used Alone

A harsh truth: the P/E is almost useless without being complemented by other indicators. A robust fundamental analysis requires evaluating:

• EPS (Earnings Per Share)
• Price/Book Value
• ROE (Return on Equity)
• ROA (Return on Assets)
• RoTE (Return on Tangible Equity)

Additionally, it is essential to examine the composition of earnings. A high profit may come from the occasional sale of a financial asset, not from the company’s operational performance. Good analysis requires dedicating time to understand the company’s fundamental magnitudes.

Undeniable Advantages of the P/E as an Indicator

Despite its limitations, the P/E offers clear advantages:

• It is easy to obtain and calculate, accessible to any investor
• Allows quick and clear comparisons between companies in the same sector
• Remains one of the three most consulted metrics by investors and professional analysts
• Works even for companies that do not pay dividends, unlike other ratios

Limitations You Must Recognize

Understanding the shortcomings of the P/E is equally important:

• Only captures benefits from one year, projecting a potentially uncertain future
• Is unsuitable for companies with negative earnings
• Provides a static snapshot, does not dynamically reflect future management evolution
• Cyclical companies are especially problematic: they show very low P/E at the cycle peak and high P/E during downturns, distorting analysis

Conclusion: The P/E as Part of a Comprehensive Strategy

The P/E is a valuable and practical tool for evaluating companies within the same sector and geography. However, relying solely on this indicator is a failed strategy. The market is full of companies with low P/E precisely because they are heading for bankruptcy, not because they represent opportunities.

Real value emerges when you combine the P/E with a deep analysis of the company’s fundamentals, other key ratios, and a genuine understanding of the industry. Spending 10 real minutes to delve into a company’s business structure transforms the P/E from an abstract number into a genuine decision-making tool. This is the foundation of any sustainable and profitable investment project.