Is using the p/e ratio the first or last metric to analyze when picking stocks?

P/E (Price to Earnings) ratios—the ratio of a stock’s price to its per-share earnings—are published regularly in newspapers and on the Internet. These financial ratios are widely followed, and are an important part of many investors’ decision making.

The standard P/E ratio involves using a stock’s current price and its earnings for the previous 12 months.

The general rule is that the lower a stock’s P/E ratio, 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. But you need more than one reliable measure to be a successful investor.

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The P/E ratio is just a starting point.

There’s no doubt that price/earnings ratios (or P/E’s) are a popular measure for investors. You’ll find them published in newspaper stock tables, and widely followed. And the P/E ratio is getting much more attention lately than, say, a year or so ago.

In early 2000, some investors who focused on tech stocks were ready to disregard P/E’s altogether. Instead they zeroed in on statistics such as the number of ‘eyeballs’ that web sites attracted, transmission speeds of wireless Internet connections and so on. These days, investors have shifted back to more traditional measures like earnings and cash flow.

Like any ratio or investment rule, this one comes with many exceptions. Some investors think the best way to pick undervalued stocks is to restrict their buying to stocks that are bargains in relation to measures like price/earnings. Some think they can even ignore investment quality and diversification if they choose low P/E stocks.

However, to profit from P/E’s, you need to put them in perspective. The P/E ratio is one of the first things you’ll look at when analyzing a stock. It shouldn’t be the only thing.

Successful investors treat P/E’s as one of many tools, not a deciding factor.

By themselves, P/E’s can steer you wrong on individual stocks, and on the market in general. 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.

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’s, and thinking that alone means you’re buying value, is often like boarding a train before it derails.

Relying too heavily on a price/earnings ratio could spell disaster.

Using the P/E ratio is a good starting point for researching a stock you’re considering buying (or selling). But relying too heavily on them can expose you to serious risk.

Here are 3 risks of relying too heavily on P/E ratios. All can seriously hurt your portfolio’s long-term returns. This is the approach we follow when we use these ratios to evaluate stocks for our newsletters and investment services:

1. One-time gains can artificially inflate a company’s earnings and lower its P/E: Make sure you factor out low P/E’s that arise if a company records a large one-time gain, such as when it sells assets. One-time gains temporarily balloon earnings and shrink the P/E ratio, and are not representative of the company’s true ongoing earnings. Similarly, you should add back any one-time write-offs, so you don’t miss any stocks that have low P/E on an ongoing basis.
2. A low P/E ratio can be a danger sign: It pays to be wary of stocks that trade at a suspiciously low P/E. 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 plunge when growth turns down. Often the riskiest time to buy stocks in these industries is when P/E’s are at their lowest.

3. Don’t discount stocks with high P/E’s: You should expect to see 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 only 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.

Key point: Because they receive so much attention in brokerage and media reports, price/earnings ratios may seem like the key to whether a stock is undervalued or overvalued. But like any other single factor, an attractive P/E should encourage you to look more closely, to see if it gives you an accurate or misleading indication of the stock’s value. Read about other issues you can run into when technically analysing stocks.

When you pick a stock, how are you using the P/E ratio formula to choose which stock to invest in?