Stop! That Stock Is Too Expensive!

The price-to-earnings (P/E) ratio is probably one of the most widely used metrics for investors trying to get a quick picture of the valuation of a stock. Part of the reason is that P/E ratios are very widely available and easy to calculate. Figuring a P/E ratio is as easy as dividing the stock's price by the company's earnings per share -- remembering to note, though, whether you're using historical or projected future earnings.

While P/E doesn't have the mathematical underpinnings of its more complex second cousin, the discounted cash flow analysis, it does allow you to quickly compare stocks with each other. Very simply, a higher P/E ratio means a more expensive stock, and a lower P/E means a cheaper stock. People often also look at a stock's P/E in relation to the average P/E of the S&P 500, which is currently (by my calculations) just less than 19 times earnings over the trailing-12-month period.

Highfliers
One of the problems with P/E is that it can be too easy to use -- it can cause investors to pigeonhole stocks and pass them over simply because they have a high P/E. Here's a quick sampling of a few stocks that had a high P/E 10 years ago but have put up impressive gains nonetheless:

There are a number of reasons why a stock might outperform despite a high P/E. For one, it might sign up new customers or launch a new business line that will vastly improve earnings but won't be seen on the books right away. A great example of this is a company that I wrote about recently, Jones Soda. A quick glance at the 100-plus earnings multiple would make many investors run, but when you consider the fact that Jones' products will soon be launching in Wal-Mart, Kroger, and Safeway stores, among others, it may be worth reconsidering the "overpriced" label.

Another way a company can break the chains of a high P/E is by being the leader in an emerging industry. Young companies in newer industries may still be trying to get their products or services into the mainstream. Despite their best efforts, this often doesn't happen -- but when it does, parabolic growth usually follows.

For example, Network Appliance finished its fiscal year that ended in April 1997 with $93 million in sales. At the time, the Internet era was still in ramp mode, and there wasn't a widespread need for extensive storage systems. Since then, data has multiplied to the nth degree, and new regulations such as SarbOx have created a need for hanging on to gobs of old files. As a leader in storage technology, NetApp was a primary beneficiary from this growing need. The company is expected to report $2.8 billion in sales for its 2007 fiscal year (ending in April), an increase of 2,911% over 1997.

Pick your poison
The moral here is that there isn't one single perfect way to make money picking stocks. Similar to Lord of the Flies, The Motley Fool's investing community, CAPS, is a place where anything goes. OK, maybe not anything, but players are allowed the latitude to pick their stocks however they see fit.

Similarly, the Fool's newsletters reflect the various flavors of investing. The Rule Breakers newsletter, run by Fool co-founder David Gardner, says nuts to P/E ratios and keeps an eye out for companies that have what it takes to outperform despite being considered overvalued by some metrics. In fact, the Rule Breaker strategy actually requires the stock to have been called overpriced by much of the financial media.

Our other newsletters, including Inside Value (focusing on value stocks) and Motley Fool Hidden Gems (seeking great but relatively unknown small-cap stocks), take very different approaches to finding market-beating returns. The rub is that they've all outperformed the S&P benchmark over their lifetimes, underscoring the idea that there isn't one "best" way to pick stocks.

So whether you're new to picking stocks or have been doing this for years, I think it never hurts to take some time away from the research reports, press releases, and SEC filings and figure out what kind of investing you're really comfortable with. If you just can't sleep well if there's a stock with a 40-plus P/E in your portfolio, you're going to have a tough time being a successful growth investor. Likewise, if terms like "tangible book value" make you want to jump out of a window, you're likely not suited for deep-value investing.

The great news is that regardless of your temperament, there's plenty of room to chalk up market-beating returns.

Fool on!

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Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out Matt's eclectic CAPS portfolio here, or get some of his other thoughts in his CAPS blog. The Fool's disclosure policy didn't have to take the red pill from Morpheus -- it can already see beyond the Matrix.