This financial ratio’s hidden drawbacks can steer you into a financial disaster

The p/e ratio (the ratio of a stock’s price to its per-share earnings) is one of many handy investing tools.

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.

There’s no doubt that p/e ratios are an important part of many investors’ decision making. These financial ratios are published regularly on the Internet and in newspapers, and are widely followed.

Financial ratios: p/e’s are just one measure of value

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 one of our newsletters, including Stock Pickers Digest, our publication for aggressive investing.

Here are 4 risks of relying too heavily on p/e ratios. All can seriously hurt your portfolio’s long-term returns:

1. P/e’s can give you a misleading picture of a company’s earnings: 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.

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2. Beware of suspiciously low p/e’s: 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.

4. P/e ratios can mask hidden value: When we’re researching a company for Stock Pickers Digest and our other newsletters and investment services, we also look closely at its financial statements to spot hidden value that’s not shown in p/e’s.

For example, companies write off research and development costs 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.

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