The P/E Ratio: How to Tell Whether a Stock Is Too Expensive Before Investing

Author: Yan Chan, capital manager at Axone Capital

2026-09-02 · 7 min read

The price-to-earnings ratio (P/E) is one of the most widely used tools in the stock market — and one of the most misunderstood. From trailing vs. forward P/E to sector effects and comparison pitfalls, here's how to actually use it to avoid overpaying for a stock.

The Analysis: What Is the P/E Ratio Really For?

When you look at a stock, the first question is simple: am I paying a reasonable price for what I'm buying? That's exactly what the P/E ratio (Price-to-Earnings) is for — a number that condenses the relationship between what you pay and what a company earns.

The formula is straightforward:

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

A P/E of 20 means you're paying €20 for every €1 of annual profit the company generates. If earnings stay flat, it would take 20 years for the company to pay back your investment — without dividends. That's the true meaning behind this figure, often recited without being understood.

Key P/E Benchmarks

  • P/E < 10: potentially undervalued, or a declining sector
  • P/E 10–20: historically "reasonable" range for US markets
  • P/E 20–30: stretched valuation, justified if growth is strong
  • P/E > 40: a bet on future growth, high risk if expectations disappoint
  • Historical S&P 500 average P/E: ~15–17 over the very long term

The Historical Fact: The Dot-Com Bubble and P/E Ratios of 100

The teaching power of the P/E ratio becomes clearest when you look at what happened between 1999 and 2001. At the peak of the internet bubble, companies like Cisco, Amazon, or Pets.com were trading at P/E ratios of 100, 200 — or even infinity for companies with no earnings at all.

The logic at the time seemed rational: these companies would dominate the digital economy. Future growth justified everything. And in some cases — Amazon most notably — that bet proved right over 20 years. But over 2 years, Amazon lost more than 90% of its value after the crash.

The historical lesson is clear: a very high P/E is not necessarily wrong if the growth materialises. But it's a bet, not an investment in the traditional sense. And that bet only pays off if future earnings compensate handsomely for the premium paid today.

The Anecdote: Buffett and Coca-Cola, the "Fair" P/E

In 1988, Warren Buffett invested heavily in Coca-Cola. The stock was trading around a P/E of 15 — in line with the market average. Yet Buffett saw an extraordinary opportunity. Why?

Because the P/E alone was not what he was looking at. He was analysing the visibility of future earnings: Coca-Cola has sold the same product for over a hundred years, with stable margins and an almost indestructible global brand. A P/E of 15 for that level of certainty was, in his view, a gift.

This is where the P/E reveals its true nature: it is not an absolute number to compare against a universal rule. It is a confidence ratio in future earnings. The more predictable and growing those earnings are, the more a high P/E can be justified.

The Concept: Trailing, Forward, and Sector Effects

In practice, there are two types of P/E to distinguish:

Trailing P/E (historical): calculated using the past 12 months' earnings. It reflects past reality — solid, but potentially outdated if the company is growing rapidly or restructuring.

Forward P/E: calculated using *estimated* earnings for the next 12 months, as projected by analysts. More relevant for valuing a growth company, but dependent on the reliability of forecasts — which can be very optimistic.

Then, sector context changes everything. Comparing a bank's P/E with a tech company's is like comparing a sailboat's speed with a Ferrari's: both figures are real, but the context is incomparable.

  • Banks and utilities traditionally trade at low P/Es (8–12) because their growth is limited but their dividends are stable.
  • Technology can justify P/Es of 30 to 50 if earnings grow 20–30% per year.
  • Cyclical sectors (auto, mining, oil) have highly variable P/Es depending on the economic cycle — often misleading at the top of the cycle.

How to Use P/E Concretely

The real best practice is to always contextualise:

  • Compare the P/E to its own historical average for the company in question. If Amazon is trading at a P/E of 40 while its 5-year average is 60, that is potentially an opportunity — even if 40 seems "high" in absolute terms.
  • Compare to the sector, not the whole market. A P/E of 12 for a fast-growing tech company is a red flag (what are they hiding?). A P/E of 20 for a bank needs a compelling justification.
  • Cross-reference with earnings growth rate (PEG ratio). If the P/E is 30 but annual earnings growth is 30%, the PEG ratio equals 1 — considered fair value. If the PEG exceeds 2, the stock is probably expensive.
  • Beware of exceptional earnings. A very low P/E can mask an abnormally good year — asset sales, one-off gains — that will not repeat.

The P/E ratio is a compass, not a GPS. It points you in a direction; it does not give you an exact price.

The Axone lesson: The stock market is not just a market of charts — it is a market of estimates about the future. The P/E forces you to ask the real question: how much are you willing to pay *today* for the earnings you hope to see *tomorrow*? Understand this number, and you will avoid the majority of valuation mistakes that beginners make.

Published on Axone Capital, capital management, macro analysis and trading by Yan Chan.