If you read anything about the stock market, you'll bump into the P/E ratio within minutes. It's the single most common way investors talk about whether a share is cheap or expensive. It's also badly misunderstood. Let's fix that — in plain language, with worked examples.
P/E in one line: the price-to-earnings ratio tells you how many rupees you're paying for each rupee of a company's annual profit. A P/E of 10 means you're paying Rs. 10 for every Rs. 1 the company earns per year — loosely, "ten years of earnings" at today's level.
The formula, made simple
There are two ways to calculate it, and they give the same answer:
- Share price ÷ earnings per share (EPS), or
- Total company value ÷ total annual profit
Let's use a made-up example. Say Ceylon Widgets PLC trades at Rs. 50 a share and earned Rs. 5 per share in profit last year.
P/E = Rs. 50 ÷ Rs. 5 = 10. You're paying ten times the company's annual per-share earnings.
That's it. The maths is trivial. The judgement is where it gets interesting.
What a high or low P/E actually means
A P/E is not simply "high = bad, low = good." It's the market's verdict on a company's future, and it cuts both ways:
- A high P/E (say 25) means investors expect strong growth — they're willing to pay up today because they believe earnings will rise. But if that growth disappoints, the price can fall hard.
- A low P/E (say 5) can mean the stock is a bargain — or it can mean the market expects earnings to fall, and has priced the stock down for good reason. A low P/E is an invitation to ask why, not an automatic "buy."
A low P/E is a question, not an answer. Your job is to work out whether the market is wrong or right.
The golden rule: only compare like with like
A P/E number means nothing in isolation. To make it useful, compare it three ways:
- Against sector peers. A bank's P/E should be judged against other banks, a manufacturer's against other manufacturers. Different industries carry different typical P/Es. Comparing a bank to a tech firm on P/E is meaningless.
- Against the company's own history. Is this stock trading above or below its usual P/E of the last few years? That tells you whether it's expensive or cheap relative to itself.
- Against the overall market. The CSE as a whole trades at an average P/E. Knowing roughly where the market sits gives you a benchmark for "expensive" and "cheap" in general.
Using P/E well
- Compare within a sector — never across unrelated industries.
- A low P/E means "ask why", not "buy now."
- Watch for one-off profits that make P/E look artificially low.
- Loss-making companies have no useful P/E — the ratio breaks down.
- Never decide on P/E alone — pair it with P/B, dividend yield, and debt.
Trailing vs. forward P/E
You'll see two versions:
- Trailing P/E uses the profit the company actually reported over the last year. It's factual but backward-looking.
- Forward P/E uses forecast profit for the year ahead. It's more relevant if the business is changing fast — but it depends on estimates, which can be wrong.
Beginners should lean on trailing P/E (real numbers) while being aware that the market is always pricing in the future.
Where P/E breaks down
P/E is useful, not magic. It fails in specific situations you should recognise:
- Loss-making companies. No profit means no meaningful P/E — the ratio is either negative or nonsensical.
- One-off distortions. If a company sold a building last year, its profit — and therefore its P/E — is temporarily flattered. Strip out one-offs to see the real picture.
- Cyclical earnings. Sri Lankan companies whose profits swing with the economy can look "cheap" (low P/E) at the top of a cycle and "expensive" (high P/E) at the bottom — the opposite of the truth.
The bottom line
The P/E ratio is a brilliant first question and a terrible last word. Use it to spot what looks unusually cheap or expensive, then dig into why — the business, the debt, the cash flow, the story. Do that, and P/E becomes what it should be: the start of your thinking, not the end of it.