How to Use the Price-to-Earnings (P/E) Ratio to Assess Stock Attractiveness?

Okay, friend, let's talk about the Price-to-Earnings ratio (P/E). Don't be intimidated by all the complicated financial jargon; it's actually much simpler than you might think.

How to Use the Price-to-Earnings (P/E) Ratio to Gauge a Stock's Appeal?

Imagine you want to buy the corner grocery store.

The store makes a net profit of 100,000 yuan per year.
The owner is asking for 1 million yuan to sell it to you.

Is this a good deal? You'd mentally calculate: If I spend 1 million to buy it and earn 100,000 yearly, then without spending a cent, it would take you 10 years to earn back your investment (1 million / 100,000 = 10 years).

This concept of "earning back in 10 years" is the core idea behind the Price-to-Earnings (P/E) ratio we're discussing today.

In the stock market:

P (Price): Is how much you pay for one share of stock (the stock price), equivalent to the "asking price for the grocery store" in the example.
E (Earnings): Is how much money the company earns annually for each share of stock (Earnings Per Share - EPS), equivalent to the "grocery store annual profit" allocated to each share in the example.

P/E Ratio = Stock Price (P) / Earnings Per Share (EPS)

Therefore, a stock with a P/E of 20, put simply, means that assuming the company's profits stay the same, it would take you roughly 20 years to "earn back" your investment through dividends or company value growth.

What do High and Low P/E Ratios Represent?

Low P/E Ratio: Typically means a shorter "payback period," suggesting the stock is relatively "cheap." Possible reasons include the market not recognizing its value, or the company facing growth challenges.
High P/E Ratio: Typically means a longer "payback period," suggesting the stock is relatively "expensive." Possible reasons include the market being very optimistic about its future, expecting significantly higher earnings, and willing to pay a premium for its "growth potential."

Just like the grocery store: if a huge residential complex were planned next door, guaranteeing booming future business, you might be willing to pay 1.5 million (a P/E of 15) or even 2 million (a P/E of 20) for it.

How to Use the P/E "Ruler" to "Measure" Stocks?

The P/E ratio itself has no absolute "good" or "bad" value; it's a comparative tool. The key is how and with whom you compare it.

1. Vertical Comparison: Compare Against Itself

Look at the range of this company's P/E ratio over the past 5 or 10 years.

Example: Suppose "Old Wang's" soy sauce company historically traded within a P/E range of 20-30. If its current P/E has dropped to 15, and the company's business hasn't deteriorated, this might represent a "discounted" opportunity worth investigating. Conversely, if it soars to 50, you should be cautious; it might be getting too expensive.

This is like knowing a piece of clothing normally sells for 500 yuan. If discounted to 300 yuan, it feels like a bargain; if priced at 800, you'd feel it's overpriced.

2. Horizontal Comparison: Compare Against Peers

Compare the company you're interested in with its direct competitors in the same industry.

Example: You want to buy stock in Appliance Company A, trading at a P/E of 15. You check other players in the industry: Company B has a P/E of 12, Company C has a P/E of 18.
- Why is A more expensive than B? Does A have better technology, a stronger brand, or faster growth?
- Why is A cheaper than C? Does C have a unique advantage, or is it just overhyped by the market?
Important Note: P/E ratios differ drastically across industries. Don't compare a bank stock with a P/E of 20 to a tech company with a P/E of 100 – that's like comparing apples and battleships by weight; it makes no sense. Banking typically has stable growth and lower P/Es; tech often has high growth potential and higher P/Es.

3. Compare Against the Overall Market

You can also reference the average P/E ratio for the entire stock market (e.g., the SSE Composite or CSI 300 index P/E). If the overall market is at historically high levels and most stocks are expensive, your chances of finding bargains are slimmer, demanding extra caution.

How Did Old Man Graham View the P/E Ratio?

Since we've mentioned Graham, the "father of intelligent investing," we must discuss his perspective. He was the pioneer of value investing and loved buying good, cheap assets.

Simple Standard: In his early works, Graham suggested looking for stocks trading below a P/E of 15. This provided him with an initial screening criterion and an important source of Margin of Safety. Buying cheap is like adding a cushion to your investment; even if the company performs worse than expected, you're protected against heavy losses.
Accounting for Growth: Graham later recognized that a rigid rule wasn't practical. A zero-growth company might deserve no more than a P/E of 8.5. But growth warranted a higher P/E. He even proposed a valuation formula where the core idea is: Reasonable P/E = Benchmark P/E + Expected Future Growth Premium.

So Graham tells us: A low P/E is a good starting point, but you must understand why it's low. Is it an undiscovered gem (a value stock)? Or is it trash no one wants to touch (a value trap)?

⚠️ Warning! The P/E Isn't Foolproof – Watch Out for These "Traps"

The P/E ratio is useful, but relying solely on it can lead you into pitfalls.

The "E" Trap: Earnings Quality A company's profits (E) can sometimes be misleading. For example, if a company sells a building, profits might spike that year, making the P/E appear very low. But that profit isn't recurring next year. Basing decisions on this "fake" low P/E will cause problems. Focus on core operating profit, excluding non-recurring gains/losses.
The Illusion with Cyclical Stocks Industries like steel, coal, and chemicals see profits closely tied to economic cycles. During booms, high sales and profits make their P/Es look particularly low, but this often signals the peak of prosperity, signaling a potential downturn ahead. Conversely, when these industries are losing money (P/Es become extremely high or even negative), it might signal the bottom of the cycle and an impending opportunity.
"Value Trap" vs. "Growth Stock" Some companies have perpetually low P/Es, yet their stock price never rallies. This could be because their industry is shrinking, or the company suffers from poor management with no hope for growth—this is a value trap. Conversely, some high-tech companies might have no profits initially (negative P/E) or a very high P/E. They might be burning cash to capture future market share; success could lead to explosive profit growth.

To Summarize

Friend, think of the P/E ratio as the first tool in your investment toolkit, not the only one.

Initial Screening: Use it to quickly gauge if a stock looks "expensive" or "cheap."
Deeper Investigation: Ask yourself the "why" questions:
- Why is it cheap? (Is it an opportunity or a trap?)
- Why is it expensive? (Is it genuine growth or pure hype?)
- Are its Earnings (E) real? Are they sustainable?
Combine with Other Metrics: Look at it alongside other metrics like Price-to-Book (PB), Dividend Yield, and Cash Flow to build a more complete picture.

Remember, the numbers are cold, but behind every investment is a living, breathing business. Understanding the business logic behind the P/E ratio will help you truly find excellent, attractive companies.