I have no doubt that the valuation tool most widely used by individual investors is the price-to-earnings ratio (P/E). Unfortunately, it may also be the most dangerous tool, because it's so misunderstood. Today, I'll talk (well, type) a little about what the P/E's problems are and how you can overcome them.

What it is
On the surface, this is a very simple and informative ratio -- a company's stock price divided by its past 12 months' earnings per share. So we can look and see that Wal-Mart (NYSE:WMT) earned $3.45 per share over the past year. At today's price of $55, its P/E ratio is $55 / $3.45 = 15.9 -- let's round it off to 16. You might also hear the hip Wall Street crowd say "Wal-Mart has a multiple of 16" -- because it sounds so cool.

Because you obviously want more earnings for every dollar you invest, a lower P/E is considered more attractive. After all, you'd rather be paying $27.50 per share for Wal-Mart for its $3.45 in earnings (P/E = 8) than $55 (P/E = 16), right?

Yes, absolutely -- why wouldn't you want to pay less for the exact same earnings stream? The same principle also applies when comparing different businesses with each other, as long as they are equal in all other respects.

What it isn't
Of course, things are never equal in the investing world (you didn't need me to tell you that), and this is where problems creep in. It's also why the P/E ratio should never be the only tool you use to value a business, for several reasons. Let's look at three of them.

1. Forward to the future
A glance at most any financial data provider tells us that Verizon (NYSE:VZ) is trading at a P/E of 16.8, while AT&T (NYSE:T) has a multiple of 13.6. So AT&T must be a better value, right?

Well ... maybe. It's rare to find two businesses that are exactly alike, and these two certainly have many differences. Also, what about earnings in the years ahead? If Verizon is able to rake in more cash than AT&T in the coming decades, wouldn't that make up for the difference in the multiples?

So there you run into a big problem with the P/E -- it's a short-sighted, usually backward-looking tool. If one company is able to double its earnings in a few short years while another remains stagnant, the former could be a much better value despite a higher multiple. Yet you wouldn't know it from the single snapshot the P/E provides.

The "forward P/E" published by some sources is a better tool, because it uses the next year's estimated earnings for the "E" part of the equation, instead of the previous year's earnings. But that still provides only a very limited snapshot. This chart illustrates just how tough it is to get a handle on this simple ratio.

Company

Estimated 2-Year Growth Rate

Trailing P/E

Forward P/E*

Wells Fargo (NYSE:WFC)

56%

26

18

JPMorgan Chase (NYSE:JPM)

98%

34

15

Morgan Stanley (NYSE:MS)

48%

21

10

Fuqi International (NASDAQ:FUQI)

32%

10

11

Data provided by Capital IQ, a division of Standard & Poor's.
*Using next 12 months' earnings estimate.

Let's look at the three banks first. The growth rates and multiples are all over the place, but all three seem to have decent forward P/Es compared to their estimated growth rates. But who can seriously trust these estimates, especially given what's happened in the financial sector over the past couple of years?

Fuqi faces a similar problem. This Chinese jeweler has put up some impressive numbers on the income statement, but the cash flow statement shows it hasn't earned a cash profit since 2006. It's a red flag for me when accounting profits consistently exceed cash profits.

As you can see, there are many, many variable to consider.

2. Focus on fundamentals
As the previous example shows, the P/E becomes more useful if you can get a grasp on just how much in earnings a company will be able to achieve over the coming years. But in order to do this, you'll need to study the underlying business and understand its margins, scalability, competitive position within the industry, etc. This fundamental analysis goes a long way toward putting the P/E in its proper perspective.

3. The fiction of accounting
Another problem comes in defining "earnings," the denominator in our equation. Like Donald Trump's hair color, it isn't always what it seems. In fact, unlike Donald's hair, it's so easy to massage and manipulate the earnings number that it's a wonder the Street still hangs on every penny. While one company may report a largely honest number, its competitor may be padding the EPS in order to "meet estimates." In the end, stuff like that usually catches up to these companies -- and, in turn, their shareholders.

My story
The best way to think about the P/E ratio reinforces what Motley Fool co-founders Tom and David Gardner tell members of their Stock Advisor investing service: You must understand that you're buying a business when you buy a stock. I'd heard that often enough, but it took a real-life example to drive the point home.

Several years ago, a friend and I considered buying a sporting goods store. It was a family-run business, with virtually no debt -- or cash -- on the balance sheet. The owner wanted $100,000 for it.

What's the most important thing you'd want to know if you'd been in our situation? Right: How much money we could reasonably expect to earn over the next few years. We didn't care about the fiction of accounting earnings (point No. 3 above). We wanted to know how much in real cash profits the business could pull in.

If it were $10,000 per year, we'd be getting the company at a P/E of 10 ($100,000 / $10,000 = 10). If it were $5,000, that's a much less attractive multiple of 20.

We dived into the fundamental analysis to figure out the real earning power of the company (point No. 2). The short story is, we thought we could make the business much more efficient (improving the margins), but future revenue and earnings growth (point No. 1) seemed very limited due to several well-financed competitors in the area.

In assessing whether this was a smart purchase, we used the three points to come up with our decision. In the end, we passed on the purchase because the P/E we calculated was over 20. Using that number hand-in-hand with our analysis, we knew it would have taken too long for us to even recoup our original investment. But the exercise itself was a lesson I'll never forget.

The lesson
Using P/E as a stand-alone valuation tool could cost you big-time. Isolating on any single metric, is a recipe for disaster.

When David recommended Amazon.com in September 2002, he acknowledged that its P/E of 75 carried risks. But his fundamental analysis convinced him the company deserved that multiple, and the stock is up more than 800% since.

If you'd like a look at all of the Gardners' recommendations, which are beating the market by an average of 51 percentage points each, consider a 30-day free trial. This also includes the top five stocks for new money now. For more information, click here.

This article was originally published June 19, 2009 as "Why the P/E Ratio Is Dangerous." It has been updated.

Rex Moore is a Fool analyst who's been cleared to operate heavy machinery. He owns no companies mentioned in this article. Amazon.com is a Motley Fool Stock Advisor selection. Wal-Mart is an Inside Value selection. The Fool has a disclosure policy.