P/e 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.

Typically, you calculate p/e’s 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, 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.

P/e financial ratios are just a starting point when you research stocks

P/e financial ratios are a good starting point for researching a stock you’re considering buying (or selling). But relying too heavily on these financial ratios can expose you to serious risk.

Successful investors treat p/e’s as just one of many tools, and not a deciding factor. This is the approach we follow when we use these financial ratios to evaluate stocks for our newsletters and investment services.

Here are 3 risks of relying too heavily on p/e ratios. All can seriously hurt your portfolio’s long-term returns:

1. One-time gains can artificially inflate a company’s p/e: Make sure you factor 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.

How Successful Investors Get RICH Learn everything you need to know in 'The Canadian Guide on How to Invest in Stocks Successfully' for FREE from The Successful Investor. How to Invest In Stocks Guide: Find 10 factors that make your investments safer and stronger.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

2. A low p/e ratio can be a danger sign: 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 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 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’d like me to personally apply my time-tested approach to your investments, you should consider becoming a client of my Successful Investor Wealth Management service. Click here to learn more.