How to use the PER to select companies: The key metric every investor must master

The Price/Earnings Ratio (What is the PER of a stock in technical terms) represents one of the most fundamental indicators in stock market analysis. However, many investors use it without truly understanding its real meaning and limitations. This article will guide you through everything you need to know about this crucial metric.

What exactly is the PER?

When we talk about what is the PER of a stock, we refer to a ratio that measures how many times the company’s annual net profit is reflected in its market price. The acronym PER comes from the English Price/Earnings Ratio, translated as Price/Earnings Ratio.

In practical terms, if a company has a PER of 15, it means that its current earnings would need 15 years to match the total value of the company on the stock market. This ratio is a mirror of investment appetite: it reflects how much investors are willing to pay for each euro of profit generated.

The PER is considered so relevant that it is part of the six essential metrics in any business health analysis, along with EPS (Earnings Per Share), P/VC, EBITDA, ROE, and ROA.

The two ways to calculate the PER

There are two equivalent approaches to obtain this metric:

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

Method 2 - Using per-share values: Divide the unit price of the stock by the earnings per share (EPS).

Both methods yield the same result. The advantage lies in the fact that the data are widely available on any financial platform, allowing any investor to verify the calculations independently.

Practical example 1

A company with a market capitalization of 2,600 million dollars and profits of 658 million would have a PER of 3.95. This exceptionally low value would suggest significant undervaluation.

Practical example 2

A stock trading at 2.78 dollars with EPS of 0.09 dollars would generate a PER of 30.9, indicating potential overvaluation or very high growth expectations.

The behavior of the PER in different contexts

Not all companies respond the same to changes in this metric. Meta Platforms (formerly Facebook) demonstrated for years how a decreasing PER correlated with sustained price increases, reflecting constant profitability growth. However, at the end of 2022, the relationship broke down: despite increasingly lower PERs, the stock price plummeted due to macroeconomic factors such as interest rate hikes.

Boeing shows another pattern: its PER remains stable within specific ranges, while the price fluctuates in line with the strength of its results.

Practical interpretation of the PER

The reading of this ratio varies significantly depending on the context:

• PER between 0 and 10: Attractive at first glance, but usually indicates that investors fear future profit declines
• PER between 10 and 17: The comfort zone for analysts, associated with balanced growth without deterioration expectations
• PER between 17 and 25: Indicates companies in accelerated expansion or potential bubbles forming
• PER above 25: Ambiguous territory reflecting extreme optimism about future projections or a clear disconnect from fundamental value

Crucially, this interpretation should never be applied in isolation. A consistently low PER in a company can mean imminent bankruptcy, not a golden opportunity.

Advanced variants of the PER

Shiller’s PER

A conceptual improvement that uses the average profits of the last 10 years adjusted for inflation, instead of only the most recent year. The theory holds that this approach, by smoothing volatility, allows for more accurate projections of the next 20 years. Its critics argue that it is equally imperfect.

Normalized PER

Adjusts the market capitalization by subtracting liquid assets and adding debt, while using free cash flow instead of net profit. This refinement was especially relevant in the case of Banco Popular’s acquisition by Santander: technically valued at 1 euro, but in reality with the assumption of multimillion debt that completely altered the actual valuation.

Sector comparability: the golden rule

One of the biggest pitfalls in PER analysis is comparing companies from different sectors. Banks and manufacturing industries typically operate with low PER (2-10), while technology and biotech companies trade with high ratios (50-200+).

ArcelorMittal, in steel, maintains a PER of 2.58, which would be considered depressed if compared to Zoom Video Communications, whose PER reaches 202.49. Both figures are “normal” within their respective sectoral contexts and business models.

The importance of combining it with other indicators

The PER never works in isolation. For a solid analysis, it should be complemented with:

• EPS: Annual earnings growth
• Price/Book Value: Relation to net assets
• ROE and ROA: Efficiency in generating profitability
• RoTE: Return on tangible equity
• Profit composition analysis: Verify if profits come from core business or one-off asset sales

The PER in Value Investing strategies

Value managers, focused on “buying good companies at a good price,” use the PER as a primary tool. Funds like Horos Value Internacional (PER 7.249 compared to 14.559 in its category) and Cobas Internacional (PER 5.466) exemplify how value managers systematically seek discounted companies relative to their peers.

Unquestionable advantages of the PER

✓ Accessibility: simple calculation available on any platform
✓ Comparative clarity: quickly identifies over/undervaluation within sectors
✓ Universality: works with companies that do not pay dividends
✓ Adoption: remains one of the three most consulted metrics by professionals

Limitations that should not be ignored

✗ Temporal myopia: only considers profits from one year to project the future
✗ Incompleteness: not applicable to loss-making companies
✗ Staticity: reflects the recent past, not the dynamic reality of future management
✗ Cyclical complexity: cyclical companies show very low PERs at cycle peaks and very high during downturns, generating false signals

The final verdict on the PER

The PER is an extraordinarily useful tool for quick comparisons between companies in the same sector and geography. However, relying solely on it is a recipe for failure. The reality is that many companies have low PERs precisely because investors rightly distrust them.

A winning strategy requires: examining the PER as a starting point, combining it with other fundamental ratios, spending time understanding the actual profit composition, and above all, maintaining a critical view of what lies behind each number. Thorough fundamental analysis, even if it takes ten minutes per company, is the difference between sustainable profitability and avoidable losses.