Smart value investors constantly search for stocks that offer huge bargains to prospective shareholders. Even after a huge rally that has lifted stock prices well off their lows, you can still find stocks trading at fairly attractive prices.

However, any time you make investment decisions based on valuations, you have to be careful. If you throw out stocks that look too expensive by simple measures of value, then you may miss out on companies whose future growth prospects justify an earnings multiple well above what you'd expect from less promising stocks.

Conversely, given how much the recession has dampened investors' appetite for stocks, you can find some stocks trading at ridiculously low P/E ratios. But if those earnings multiples are based on past earnings that the company is unlikely to meet again in the near future, then you could be in for a big surprise when you see earnings drop, making what seemed a bargain appear much more expensive.

What the future holds
Low P/E ratios shouldn't automatically make you salivate over a stock. Bear in mind that the vast majority of investors aren't stupid, so there's almost always a good reason share prices are as low as they are. After you take a closer look, you may find out what that reason is -- and it may save you from making a huge investing mistake.

For instance, the following stocks trade at relatively low P/E ratios that certainly look attractive at first glance. But when you look at how Wall Street expects those companies to perform in the future, you'll notice that their earnings will probably fall -- in some cases dramatically -- pushing forward P/E ratios much higher than the current trailing P/E:


Current Trailing P/E

Projected Forward P/E

Cardinal Health (NYSE:CAH)



Discover Financial Services (NYSE:DFS)



Sunoco (NYSE:SUN)



U.S. Steel (NYSE:X)



Tenet Healthcare (NYSE:THC)



Source: Yahoo! Finance.

Moreover, the same trap lurks even within stocks that don't look as cheap as the ones above. Titanium Metals (NYSE:TIE), for instance, trades at 18 times trailing earnings right now. But based on fiscal year 2010 projections, the current stock price is a whopping 45 times forward earnings. Similarly, Starwood Hotels & Resorts Worldwide (NYSE:HOT) doesn't look overpriced at 19 times trailing earnings -- but with a forward P/E of 57, value investors will want to think twice before committing their capital to the stock.

What to watch out for
None of this means those stocks are necessarily bad bets. But the difference between a stock's trailing and forward P/E ratio is just one more reason that relying on a single, simple measure of valuation can lead you in exactly the wrong direction. To make sure you have a complete view of a company's financial picture, there are some other steps you really need to take.

For instance, look at quarterly financial reports to identify extraordinary items that you're not likely to see very often. If a company has a one-time income boost, it'll push trailing P/Es down, but earnings will fall back to normal in subsequent quarters. You can also look at other types of financial figures, such as cash flow, to verify whether earnings numbers based on accounting rules are backed up by actual money coming in.

In addition, you should be familiar with other stocks in the industry and the valuations that the market typically assigns to them. What may appear to be a low P/E compared to the overall market may actually be fairly pricey for a particular industry, especially those that lack strong growth prospects.

Be smart
As an investor, you'll always find it disappointing when a promising candidate turns out not to be as good as it first appears. But if you want to be a successful investor, you have to realize that refusing to settle for second-best stocks is what separates the best stock pickers from the crowd. Once you realize you can afford to wait for the absolutely best ideas to appear rather than dumping your money into the first decent stock that crosses your computer screen, you'll be well on your way toward improving your long-term results.

Hoping to get back into the market at lower prices? Shannon Zimmerman explains how you can prep for the next pullback now.

Fool contributor Dan Caplinger spends way too much time looking for great values. He doesn't own shares of the companies mentioned in this article. Titanium Metals is a Motley Fool Stock Advisor selection. Discover Financial Services is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy always gives you great value.