There’s no doubt that p/e (price-to-earnings) ratios are a major part of many investors’ stock research. They are published regularly on the Internet and in newspapers, and are widely followed.

The p/e is the ratio of a stock’s market price to its per-share earnings. Generally, the rule is that the lower the p/e, the better, and a p/e of less than, say 10, represents excellent value. A low p/e implies more profit for every dollar you invest. Typically, when you do stock research, you calculate p/e’s using a stock’s current price and its earnings for the previous 12 months.

P/e ratios are just one measure of value

Successful investors treat p/e’s as just one of many tools for conducting stock research, not a deciding factor. This is the approach we follow when we look into a stock’s performance for one of our newsletters, or in response to a question from a member of our Inner Circle service.

That’s because by themselves, p/e’s can steer you wrong on individual stocks, and on the market in general. As well, there are lots of stocks out there that are cheap on a p/e basis. But many will remain cheap — their share prices won’t be rising any time soon.

When conducting stock research, you need to ask yourself if a p/e is telling you something by being unusually high or low. In the worst cases, buying stocks with low p/e and thinking that alone means you’re buying value, is often like boarding a train before it derails.

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Earnings: Quality is just as important as quantity

When your stock research involves examining p/e ratios, it’s important to verify the “quality” of the earnings. This involves factoring out low p/e’s that arise if a company sells off assets or subsidiaries and records a large one-time gain. (That inflates the p/e, and is not representative of the company’s true ongoing operating earnings.) Similarly, you should add back any one-time write-offs so you don’t miss any stocks that have low p/e’s on an ongoing basis.

As part of our stock research, we also look closely at a firm’s financial statements to spot hidden value that’s not shown in p/e’s. For example, companies write off research and development outlays against earnings in the year they spend the money, though benefits may come years later. Attention to research spending has guided us to some of our biggest winners. Because these companies spend heavily on research, they are more profitable and less risky than you’d guess from looking at their high p/e’s alone.

It pays to be wary of stocks that trade at suspiciously low p/e’s. Low p/e’s may come about because well-informed investors are selling the stock and pushing the price down, regardless of earnings. In other words, unusually low p/e’s can be a sign of danger rather than a clue to a bargain.

Some companies, especially in the cyclical Manufacturing and Resources sectors, go through periodic booms and busts that can balloon their earnings in the space of a few quarters, then deflate them overnight. If earnings are high and p/e’s are low on a company or industry, it usually means investors expect a profit setback. These stocks could easily drop to a few pennies, or a loss, when growth turns down. Often the riskiest time to buy stocks in these industries is when p/e’s are at their lowest.

High p/e’s can be profitable, too

You should expect to pay high p/e’s for stocks with lots of growth potential. As well, you may want to buy shares of high-p/e firms that report earnings even in bad times. This shows a high-quality company. This is true even if a company stays marginally profitable, or avoids eye-catching losses, in bad times.

You’ll also pay more for companies with a long-term earnings pattern. However, few are worth more than 20 to 25 times normal earnings in the midst of an economic cycle. So you should avoid loading your portfolio up with high-p/e stocks. Should the market go into a broad setback, these stocks are particularly vulnerable.

If you have questions about financial ratios or any other investment-related issues, you should join our Inner Circle service. Click here to learn more.