Deciphering the PER Ratio: The Key Tool Every Investor Must Master

When it comes to evaluating companies in stock markets, there is an indicator that practically no analyst dares to ignore. We are talking about the PER, a metric that transcends simple mathematical calculation to become a window into the financial health and growth prospects of any listed company.

Why is the PER the King of Fundamental Analysis?

The PER represents the relationship between a stock’s market price and the profits the company generates periodically. Its initials stand for Price/Earnings Ratio, or more directly: Price/Profit Ratio. This indicator integrates a select group of six essential metrics to understand the true state of a corporation, along with EPS, P/VC, EBITDA, ROE, and ROA.

Essentially, the PER answers a fundamental question: how many years would the company’s current profit need to match its total market capitalization? If a company has a PER of 15, this means that its extrapolated profits over twelve months would fully cover the company’s stock price in fifteen years.

The importance of the PER is not limited to serving as a simple comparative tool. It also acts as a mirror reflecting how corporate profitability evolves over time, allowing the detection of expanding companies versus those that stabilize.

The PER Formula: Two Paths, One Destination

There are two equivalent ways to calculate this ratio, each providing identical results but from different perspectives.

Method 1 - Using aggregate figures: Divide the company’s market capitalization by its total net profit.

Method 2 - Using per-share data: Take the stock price in the numerator and divide by EPS (profit per share).

Both approaches produce the same result because they work with the same values, just aggregated differently. The advantage lies in the fact that the necessary data are widely available on any financial platform, making the calculation of the PER an accessible operation for any interested investor.

Interpreting the Signals Sent by the PER

The values this metric yields are not arbitrary; each range communicates different messages about a company’s valuation:

PER between 0 and 10: Considered attractive from a price standpoint, but this low figure may also indicate that profits could contract in future periods. Deep investigation into the causes of this depression is required.

PER between 10 and 17: Represents the preferred range for most analysts. Here, companies show medium-term expansion potential without compromising future earnings expectations.

PER between 17 and 25: This gray zone admits two interpretations: the company has undergone significant growth since the last earnings report, or we are witnessing the first signs of overvaluation. Sector context is crucial.

PER above 25: Here, the interpretation becomes particularly ambiguous. It may reflect extraordinarily optimistic projections about the company, suggesting future returns of considerable magnitude. But it can also indicate that the speculative bubble is already evident.

Real Cases: When Behavior Defies Expectations

Theory states that when the PER decreases while the stock price rises, we are looking at a company growing in profitability: the scenario that Meta Platforms (formerly Facebook) illustrated perfectly in its early listed years. As the company expanded its profits, its PER compressed, rewarding early investors with increasingly attractive valuations.

However, from late 2022, this pattern broke. Meta’s stock price fell despite its PER ratios continuing to improve. The reason? Rate hikes implemented by the Federal Reserve radically changed market appetite for tech assets, regardless of their improved results.

A different case is Boeing, where the PER remains relatively stable within a specific range, with the stock oscillating in sync with these movements. The most relevant distinction here is not the volatility of results but their sign: whether they are positive or negative.

Beyond the Conventional PER: Specialized Variants

Shiller’s PER: The Long-Term Perspective

One of the most well-founded criticisms of the traditional PER is that it relies solely on data from one fiscal year, capturing only an instant snapshot that can be excessively volatile or atypical. The main difference between the ordinary PER and Shiller’s PER lies in the time horizon used.

Shiller’s PER broadens this perspective by using the average of profits over the last ten years, adjusted for inflation. The underlying theory proposes that this decade of historical data provides enough information to project profits more reliably over the next two decades.

The Normalized PER: Adjusting the Financial Lens

There is also a variant called the normalized PER that shifts the focus from the calculation period to the overall health of the company’s financial structure. In this case, market capitalization is taken, available liquid assets are subtracted, and outstanding financial debt is added. Instead of conventional net profit, free cash flow is used in the denominator, allowing to “separate the wheat from the chaff,” as professionals often say.

An illustrative example is the acquisition of Banco Popular by Banco Santander for a theoretical euro. Although nominally it seemed like a symbolic purchase, Santander was actually assuming a colossal debt, which caused other entities like Bankia or BBVA to withdraw from the bidding. The normalized PER would have immediately revealed this hidden reality.

Comparing Companies: How to Know if They Are Overvalued?

The practical usefulness of the PER emerges when we use it to compare companies within the same sector. A high PER generally suggests that the company is trading at disproportionate levels relative to its current earnings. Conversely, a low PER typically indicates that the market values it below its true potential, presenting a buying opportunity.

But an important complication arises here: different economic sectors operate with completely different PER structures. Banking and industrial industries traditionally maintain low ratios, while technology and biotech companies display stratospheric PERs.

ArcelorMittal, a giant in metallurgy, trades at a PER of just 2.58. In contrast, platforms like Zoom Video — whose relevance skyrocketed during the pandemic — boast a PER of 202.49. Comparing both directly using identical criteria would be a serious analytical mistake. Therefore, the fundamental principle is always: compare “apples with apples and oranges with oranges.”

The Indissoluble Link Between PER and Value Investing

Practitioners of the Value Investing philosophy — seeking good companies at attractive prices — have made the PER their favorite tool. Benchmark funds in this strategy, such as Horos Value Internacional, show PERs of 7.24, significantly below the category average of 14.56. Cobas Internacional exhibits similar patterns, reflecting how this investing community consistently uses low ratios as an entry point into their portfolios.

The Real Limitations of the Indicator

Despite its omnipresence, the PER has significant shortcomings that should not be ignored:

Temporal limitation: It only incorporates data from one fiscal year, projecting future profits from a potentially anomalous or cyclical base.

Inapplicability to unprofitable companies: If a company does not generate profits, the PER becomes a meaningless number or impossible to calculate.

Static nature: It reflects a snapshot of the moment, not the future dynamic trajectory of management or its foreseeable evolution.

Problems with cyclical companies: During the peak of the economic cycle, these show low PERs due to maximum profits, while in cyclical depression, the PER skyrockets. This can lead to incorrect contracyclical investment decisions if only this ratio is considered.

Combining the PER with Other Fundamental Analysis Tools

The critical premise guiding any investment strategy is that the PER should never be the sole compass. It must be complemented with other ratios such as Price/Book Value, ROE (Return on Equity), ROA (Return on Assets), or RoTE (Return on Tangible Equity).

Furthermore, rigorous fundamental analysis demands a thorough examination of the composition of the main business lines. An exceptionally high profit might not reflect actual operational performance but rather a one-time sale of a financial asset held on the balance sheet.

Undisputed Strengths of the Indicator

Despite its limitations, the PER retains significant advantages:

✓ Its calculation is straightforward, and the required data are widely available publicly.

✓ It allows quick, clear, and precise comparisons between companies in the same sector without additional complexities.

✓ It remains one of the three most consulted ratios by analysts and global institutional investors.

✓ It works correctly even in companies that do not pay dividends, something not true for all available metrics.

Conclusion: A Powerful Tool, But Not Omnipotent

The PER is undoubtedly one of the pillars of fundamental analysis, especially valuable for comparisons between companies in the same sector and facing similar market conditions. However, building an investment strategy based solely on this ratio would be doomed to failure.

The history of capital markets is full of companies with depressed PERs precisely because the market has lost confidence in them, placing them closer to insolvency than prosperity. Conversely, companies with seemingly exuberant valuations have generated extraordinary returns.

The practical conclusion is to spend time understanding the company comprehensively beyond the numbers, using the PER in conjunction with other key indicators, and allowing this rigorous analysis to underpin truly profitable and sustainable investment decisions.