How to Evaluate if a Company is Fairly Valued Using the PE Ratio?

Jan 233 min read

Updated: Feb 19

Disclaimer: This communication is provided for information purposes only and is not intended as a recommendation or a solicitation to buy, sell or hold any investment product. Readers are solely responsible for their own investment decisions.

When analyzing whether a company is fairly valued from a PE ratio perspective, it’s important to assess more than just the absolute value of the ratio. The following framework provides a systematic approach to determine if the company is trading at a reasonable valuation:

A Company’s PE Ratio is Considered Fairly Valued When:

The Current PE Ratio is Below the Average or at the Low End of the Past 5 Years PE Range
- This indicates that the stock might be undervalued compared to its historical valuation trends.
The Company’s Net Income is Increasing
- Rising net income ensures that the company is not just cheaper because of declining profitability but is instead delivering consistent growth in earnings.
- Preferably when the past Net Income growth rate + Dividend Yield is higher than current P/E ratio [1]
- Not favourable when the current P/E ratio is higher than past Net Income growth rate + Dividend Yield multiply by 2 [1]
The Profit Margin is Increasing
- An expanding profit margin suggests improved operational efficiency, pricing power, or reduced costs, further supporting sustainable earnings growth.

How to Find the PE Ratio Trend?

To assess a company’s PE ratio over the past 5 years:

Visit financecharts.com > Valuation Charts > Select PE Ratio > Adjust to a 5-year (or 3-year) period.
- For companies that have only recently turned profitable, the 3-year period may provide more meaningful insights.

Examples of Companies That Fit the Framework

1. Fortinet (FTNT) – PE Ratio: 46x

✅ PE Ratio: Current PE is below the average line of the past 5 years.
✅ Net Income: Increasing consistently.
✅ Past Net Income Growth rate (52%) higher than current P/E ratio (46x)
✅ Profit Margin: Improving steadily.

2. Netflix (NFLX) – PE Ratio: 48x

✅ PE Ratio: Current PE is below the average line of the past 5 years.

✅ Net Income: Rising steadily.
✅ Past Net Income Growth rate (61%) higher than current P/E ratio (48x)

✅ Profit Margin: Increasing over time.
📌 Additional Note: Netflix’s management has outlined clear strategies to enhance profitability, such as increasing subscription prices, which could positively impact their bottom line.

3. MercadoLibre (MELI) – PE Ratio: 64x

✅ PE Ratio: Current PE is below the average of the past 3 years (5 years not usable).
✅ Net Income: Growing steadily.

however past year Net Income Growth of 46% is not higher than current PE ratio of 65x.

✅ Profit Margin: Gradually improving.

Examples of Companies That Don’t Fit the Framework

1. Apple (AAPL) – PE Ratio: 37x

❌ PE Ratio: Current PE is above the average line of the past 5 years.
❌ Net Income: Flat or declining.
❌ Profit Margin: Moving sideways, showing no improvement.

Notes on Limitations of this Method

This method is not as applicable to companies that are:

Not Yet Profitable: Without earnings, the PE ratio isn’t meaningful.
Just Turned Profitable: In such cases, it’s better to use the PS (Price-to-Sales) Ratio for valuation analysis.
- 📖 For more insights, read: Avoid Investing in Stocks with PS Ratios Above 18x When Stock is at All-Time High Level.

Final Thoughts

By combining the PE ratio trend with growth in net income and profit margins, you can form a more holistic view of whether a stock is trading at a fair valuation. This method is especially useful for investors focused on fundamentally strong companies that are still undervalued relative to their historical performance.