How to use the P/E ratio to evaluate stock value

Main Idea

The P/E ratio (price/earnings) is a simple way to understand whether a stock is fairly valued. It shows how much money investors are willing to spend to gain one dollar of the company's profit. The lower the ratio, the cheaper the company looks relative to its earnings. The higher it is, the more investors believe in its future growth.

How to calculate P/E: the basic formula

The calculation is simple and straightforward:

P/E = stock price ÷ earnings per share (EPS)

Where the formula eps looks like this:

EPS = (net profit of the company after taxes) ÷ (number of common shares)

This EPS formula shows the profit a company generates per share. Knowing this figure makes it easy to calculate the basic ratio.

Types of P/E Ratio

In practice, four main options are used:

Current P/E — calculated based on earnings for the last 12 months. These are actual results, already confirmed by the company's reports.

Forecast P/E — is based on expected earnings for the next 12 months. Analysts make forecasts, but the results are still unknown.

Absolute P/E - a simple calculation without comparisons, just the current stock price divided by the last earnings per share.

Relative P/E - the company's ratio is compared with competitors in the industry or with the historical average of the same company. This helps to determine whether the stock is expensive by the standards of its sector.

How to Interpret the Results

A high ratio can mean two things: either the market believes in the company's high future growth and is willing to pay a premium, or the stock is overvalued.

A low ratio indicates that either the stock is undervalued or the company is facing issues that scare investors.

But “high” and “low” are relative concepts. Technology companies usually have higher ratios because they grow faster. Utility companies have low ratios because they grow slowly but steadily. It is meaningless to compare a technology company with a utility company based on this indicator.

When P/E is Useful

This tool will be especially useful in several situations:

Quick comparison — if there are two companies in the same industry and one has a much higher P/E, it's worth investigating why. It might be that it is truly better, or it could be overvalued.

Searching for Undervalued Stocks — investors use low ratios as the first filter when looking for potentially profitable investments.

Analysis of historical data — if a company's ratio has increased over the past few years, this may indicate a growing market confidence in its prospects.

Main Issues and Limitations

The coefficient is not a panacea. It has serious drawbacks:

Does not work with unprofitable companies — if a company is losing money, the ratio is simply impossible to calculate.

Does not show growth rate — two P/E ratios can be the same, but one company grows 10 times faster than the other. The EPS formula does not take dynamics into account.

Subject to manipulation — crafty accountants may reclassify expenses to make profits appear better than they actually are.

Ignores debts and cash flows - the ratio does not indicate how heavily the company is indebted to banks or how well it is managing its cash.

Due to these restrictions, investment decisions cannot be made solely based on P/E. It is necessary to look at revenue, net profit, debt levels, and other metrics.

P/E in different industries

P/E varies significantly depending on the type of business:

• Technology companies often trade with a P/E above 20-30 because they grow quickly.
• Financial sector companies typically have a P/E of 10-15
• Utility companies rarely exceed a P/E of 15-20 because their growth is predictable and low.

This is normal and expected. Comparisons should only be made between companies in the same industry.

Is P/E Applicable to Cryptocurrencies

The simple answer is: no, not applicable.

The P/E ratio requires a company to report its earnings. But most cryptocurrencies and blockchain projects do not generate profit in the traditional sense. They do not have revenues like companies that sell goods or services.

The only exception is some decentralized finance protocols (DeFi), which do indeed earn fees. Analysts sometimes try to apply similar metrics, for example comparing the token price with the volume of fees generated by the platform. But these are experimental approaches that have not yet settled and become the standard.

Final Conclusions

The P/E ratio is a useful but not universal tool. It provides a quick snapshot of whether a stock is expensive or cheap relative to its current earnings. The eps formula and basic calculation are simple to apply, which makes this ratio popular among investors.

However, it should only be used as a starting point for analysis, along with other indicators. Do not rely solely on P/E - look at the company's fundamental metrics, its growth, market position, and the specific situation in the industry.