The price-to-earnings（P/E）ratio is probably the most well-known of all the valuation methods. However, many people may not know how to use it correctly. This section will give you a comprehensive introduction to the scope of application and usage of P/E ratios.

1. What is the P/E ratio?

First, let’s review the definition of the P/E ratio. The P/E ratio refers to the ratio of stock price to earnings per share, which equals the total market capitalization divided by the net profit.

For example, if the total market value of Company A is US$1 trillion at the closing of a trading day, and its net profit in 2021 is US$5 billion, then the P/E ratio of Company A based on the profit in 2021 is 10,000/50=200 times.

It is worth noting that the most important thing for investors is the continuous profitability of listed companies. One-time gains and losses such as government subsidies or investment income (loss) can be excluded from the net profit so that the adjusted P/E ratio calculated is more effective.

The P/E ratio can be divided by time into static P/E ratio, P/E Ratio - trailing 12 months (TTM), and dynamic P/E ratio.

A static P/E ratio is calculated based on a company's performance over the past fiscal year. The valuation of Company A in the above example is the application of a static P/E ratio.

The TTM is a valuation based on the aggregate of a company's performance over the past 12 months. For example, after Company A announces its 2022 Q1 quarterly report, its profit in the first quarter of 2022 and the profit in the next three quarters (Q2-Q4) of 2021 add up to $6.5 billion, so Company A's TTM is 10,000/65 = 153.8 times.

The dynamic P/E ratio is a valuation calculated based on a company's expected performance in a future fiscal year. For example, if you expect the net profit of company A in 2022 to be US$12 billion, then its dynamic P/E ratio is 10000/120=83.3 times.

Many individual investors prefer to use the TTM because it is easy to calculate and can reflect the performance of the company's latest earnings report. However, some institutional investors prefer to use a dynamic P/E ratio because they can collect more data through research, thus making more professional predictions about companies' performance.

2. Which companies does the P/E ratio apply to?

We all know that there is no one-size-fits-all valuation method. The P/E ratio is mainly applicable to companies that have stable profitability.

If a company doesn't have earnings data, it's impossible to calculate a P/E ratio. At the same time, if a company's earnings are unstable, the calculated P/E ratio will fluctuate and cannot be tracked for a long time.

A company with a stable profit mainly refers to a company whose net profit remains stable or maintains continuous growth for a long time. From the industry life cycle perspective, companies with stable profits are mainly those in the growth or maturity phase of the industry with a certain scale.

For example, Philip Morris's performance in the US tobacco industry is very stable, and its net profit in 2021 is not much different from that in 2011. Tesla's performance has remained strong in the past few years in the growing new energy vehicle industry.

3. How to assess the P/E ratio?

After calculating a company's P/E ratio, it is also necessary to evaluate the results to see whether it is overvalued or undervalued from the following three dimensions.

First, compare P/E ratios with the industry average. Listed companies in different industries may have very different P/E ratios, and only comparing valuations in the same industry is meaningful.

A leading company in the industry may have a higher valuation than the industry average. If a company's industry position is relatively low, it may also be cheaper in terms of valuation.

Source: moomoo app

You can gain information about P/E ratios on moomoo. First, enter the "Detailed Quotes" page of stock, tap "Analyses," and then tap "Fundamental."

Second, compare P/E ratios with a company's historical ratios. A stock's P/E ratio is not set in stone and will change with the fluctuations in share price and performance. We need to pay attention to the historical quantiles of a company's ratio. If a company's current ratio is higher than most of its history, it may be overvalued. Otherwise, it may be undervalued.

Third, assess it via the PEG indicator, which is a stock's P/E ratio divided by the earnings growth. PEG = P/E ratio / expected growth rate of net profit. Generally speaking, the lower the PEG of stock, the better. Because the higher the company's expected growth rate, the higher its future profits and the lower its dynamic P/E ratio.

According to some market opinions, when a stock's PEG is greater than 1, it is considered overvalued, while a stock with a PEG of less than 1.0 is considered undervalued. However, if a company's growth rate is expected to be high, its PEG level may be much greater than 1. In this case, even when PEG=2, it is not necessarily overvalued.

In addition to the evaluation criteria of the above three dimensions, many factors affect a stock's P/E ratio, such as a company's business model, profitability, and cash flow, which we will analyze in the following sections.

That's all for the introduction of the P/E ratio. After reading this section, we hope you can better understand the definition, scope of application, and evaluation criteria of the P/E ratio. In the next section, we will introduce the price-to-book (PB) ratio and price-to-sales (PS) ratio.