Buying the best stocks requires proper info, like understanding P/E ratios in conjunction with other financial metrics. That’s a great starting point for successful stock picking

Now is a particularly good time to avoid formulaic responses to investment questions and dilemmas. For example, some investors look at P/E ratios as a great guide to investment value.

P/E ratios (the ratio of a stock’s price to its per-share earnings) are widely available online and in various publications. The P/E is a key part of many investors’ decision making, and today we will provide information so understanding P/E ratios becomes an investment skill of yours.

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Understanding P/E ratios is important, including these three risks of relying too heavily on this metric

1. One-time gains can artificially inflate a company’s earnings and lower its P/E: Make sure you factor out a low P/E that arises because a company records a large one-time gain, such as when it sells assets. One-time gains may temporarily balloon earnings. This shrinks the P/E ratio. However, asset sales can mislead you about a company’s long-term earnings potential. The remaining operations may not be able to generate substantial profit.

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—one that is well below average. Low P/Es may come about because well-informed investors are selling the stock and pushing the stock price down, regardless of earnings. In other words, unusually low P/Es can be a sign of danger rather than a bargain.

Some companies, especially in the cyclical manufacturing and resources sectors, go through periodic booms and busts. These cyclical fluctuations can balloon their earnings in the space of a few quarters, then deflate them just as quickly. If earnings are high and P/Es are low on a company or industry, it usually means investors expect a profit setback.

Often the riskiest time to buy stocks in cyclical industries is when profits are high and P/Es are at their lowest.

3. Only pay high P/Es for stocks that offer great opportunities. Stocks with lots of growth potential often trade at high P/Es. As well, some high-P/E firms consistently manage to make some money and report earnings even in bad times. This is a sign of a high-quality company.

However, avoid loading up your portfolio with high-P/E stocks. If the market goes into a broad setback, high-P/E stocks tend to be particularly vulnerable.

One of today’s most common formulaic investment opinions is to assume that stocks and/or the market are over-priced because P/E ratios are at historically high levels. We strongly disagree. Right now, we see a variety of great long-term opportunities in the market, with widely varying P/Es. 

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. You need to ask yourself if a P/E is telling you something by being unusually high or low. 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.

Understanding P/E ratios in conjunction with these other financial ratios will help you make better stock picks

Price-to-book ratio: The book value per share of a company is the value that the company’s books place on its assets, less all liabilities, divided by the number of shares outstanding. Book value per share is a rough approximation of the actual value of the company’s assets. It represents a “snapshot” of an instant in time, and could change even the day after the financial statements are issued.

When we find a stock with a low price to book value, we look to see if the price is too low, or if the book value per share is inflated. Most often, it’s because the price is too low. But, sometimes, assets are about to be written down. In that case, the stock should be avoided.

Price-sales ratio: This measure represents the ratio of share price to per-share sales and is not as widely known. Still, it can be even more important in pinpointing an undervalued stock. Sales are more stable than earnings, so a company’s p/s ratio can tell you more about it than its p/e. Sales are less subject to manipulation by management or distortion by accounting rules.

Price-cash flow ratio: Cash flow can actually be a better measure of a company’s performance than earnings.

Cash flow is really a measure of the cash flowing into a company with less cash outlays. Simply put, it’s earnings without taking into account non-cash charges such as depreciation, depletion and the write-off of intangible assets over time. Cash flow is particularly useful in valuing companies in industries where depreciation and depletion charges are based on the historical value of assets, rather than current values.

Use our three-part Successful Investor approach to find the best stocks for your portfolio 

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight. 

What financial ratios do you use before making investments?

What is your opinion on using financial ratios to help you make investing decisions?