How the Wrong Stocks Can Get You in Trouble

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Millions of investors judge whether a stock is right or wrong for them based on a single measure of their valuation: the ratio of its price to its earnings. While the P/E ratio gives you some valuable information, it doesn't give you nearly enough to make a smart investing decision -- and more often than not, it can prove extremely misleading, which can get you into the wrong stocks at the wrong time.

Why P/E is so important
The appeal of the P/E ratio is undeniable. When you look at broad market trends, you'll notice that the overall earnings multiple of the stock market as a whole acts as a pretty strong predictor of future returns. In other words, when the market's P/E ratio is low, you can expect future market returns to be above average; but when the multiple is high, future returns tend to lag behind their historical norms.

All that makes perfect sense intuitively. If a high P/E ratio means that stocks seem expensive, you'd expect them to perform badly as they revert back to a cheaper mean. Conversely, cheap stocks tend to attract value investors looking for exactly the gains they then tend to see.

But when you use the P/E ratio as a comparison tool among various individual stocks, you have to be much more careful. Often, you can't make conclusions about whether a stock is cheap or not based solely on its P/E compared to some other stock.

Taking a snapshot
As an example, let's look at five stocks that have roughly the same P/E ratios:

Stock

P/E

3-Year EPS Growth Rate

52-Week Price Change

General Electric (NYS: GE)

11.8

(14.7%)

(5.6%)

Kroger (NYS: KR)

11.8

(12.4%)

3.6%

Teck Resources (NYS: TCK)

12.1

15.9%

7.5%

Dolby Labs (NYS: DLB)

12.1

14.0%

(41.8%)

Tim Hortons (NYS: THI)

12.2

38.7%

25.6%

Source: Motley Fool CAPS as of Sept. 12.

As you can see, these stocks pretty much span the gamut as far as their past pedigrees are concerned. General Electric was the biggest stock in the market more than a decade ago, yet it has fallen from grace as its financial division ate a huge chunk out of its profits during the mortgage meltdown. Kroger never had GE's scope but has seen a similar contraction in its core business income. On the opposite side of the spectrum, Teck Resources and Tim Hortons have tapped into some basic fundamental needs, and while metals and doughnuts might not seem to have much in common, the two stocks are clearly on a better growth trajectory than their much larger counterparts in the table. Meanwhile, Dolby Labs has seen continuing share growth, but unlike Teck and Tim Hortons, the sound specialist hasn't gotten appreciation from investors, who have punished its shares.

A moment in time
The other thing about P/E ratios is that they change all the time -- and not just because share prices move up and down. The earnings denominator also has a marked impact on P/Es that investors ignore at their peril.

For instance, take Pfizer (NYS: PFE) . Looking at expected 2011 earnings, the company looks attractive, with a multiple of about eight. But next year, analysts don't expect the company to grow earnings more than 2%, and it's entirely possible that with the loss of big drugs like Lipitor in the near future, Pfizer's earnings could begin to shrink. By contrast, Apple (NAS: AAPL) shares fetch a trailing P/E of 15, but with much faster growth, that figure drops to 14 for fiscal 2011 and less than 12 in fiscal 2012. If you ignore growth and go with Pfizer due solely to its lower P/E ratio, you may find that even if their stock prices stay constant, Apple's P/E could be lower than Pfizer's in the near future.

Look beyond the obvious
Simple measures of value are compelling for beginning and experienced investors alike. But you should only use them as starting points for more in-depth research. If you rely solely on the P/E ratio, you'll quickly learn about its shortcomings -- the hard way.

If you want some good ideas for stocks that combine good valuations with strong future prospects, take a look at the Fool's free special report, "5 Stocks the Motley Fool Owns -- And You Should Too." In it, we share some of our best picks -- and tell you how you can cash in on them.

At the time this article was published

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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