The more you know about investing, the more successful you will be. That has been Pat McKeough’s approach through four decades as an investor and investment counsellor. He regularly presents his views on specific investment topics on video in order to share the insights he has gathered over the years.

In today’s video, Pat points out that while the knowledge you acquire is certain to enhance your success an investor, it is also true that a little knowledge can be a dangerous thing.

That applies to one of the mainstays of stock research, the price/earnings ratio (the current share price divided by earnings per share). As a staple of stock quotes, the p/e ratio is widely used as a guide to the future profitability of a stock. But when it’s used on its own without taking other factors into account, Pat observes, it can lead to very costly mistakes.

The transcription of his You Tube talk is below.

Pat McKeough: P/e ratios are the first investment tool that most people learn about. And the knowledge of p/e’s sticks with investors for a long time after they’ve learned a lot of other things about investing. When looking at a new stock, investors tend to zoom in on p/e ratios and maybe to read more into p/e ratios than they should.

And I can tell you two of the worst rules you’ll ever find in wide use in the investment business. One is that somehow a low p/e ratio is always great. Not true! A low p/e ratio can be a sign of danger; it may mean there’s insider selling going on that’s pushing down the stock price in relation to the earnings. So I would say that if you see a low p/e ratio it might be a good deal, but you have to look closer. You have to see what else is going on.

The other bad rule is that a high p/e ratio is automatically a danger sign. Sometimes p/e ratios get high and stay high for months if not years. There was a period in the 1960s when a group of stocks called the Nifty Fifty were trading at 50 to 100 times earnings and it went on like that for years. If you sell automatically because the p/e ratio got higher than you’d like, you will often wind up selling your best picks way too early.

So the message on p/e ratios is that they’re a good place to start but you can’t make a decision based on them alone. You really need to look at other factors like those we talk about in our publications.

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Is there one indicator you rely on more than others when you are looking to buy a stock? In the end, do you rely on ratios and other numbers, or do you go with your gut feeling when you make a decision? Let us know what you think in the comments section below. Click here.