I have no doubt that the most widely used valuation tool 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 last 12 months of earnings per share. So we can look and see that Monsanto earned $4.10 per share over the past year. At today's price around $81.30, its P/E ratio is $81.30 / $4.10 = 20. You might also hear the hip Wall Street crowd say "Monsanto has a multiple of 20" -- 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 $40.65 per share for Monsanto's $4.10 in earnings (P/E = 10) than $81.30 (P/E = 20), 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, 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 Cisco Systems (Nasdaq: CSCO) is trading at a P/E of 16. Juniper Networks (Nasdaq: JNPR) has a multiple of 31. So Cisco must be a better value, right?

Well … maybe. It's rare to find two businesses that are exactly alike, and these two certainly have their differences. Also, analysts estimate Juniper will grow earnings about 18% annually over the next five years, while Cisco is only projected to grow at around 10% per year. 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 picture 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*

Apollo Group (Nasdaq: APOL)

69%

16

15

USEC (NYSE: USU)

91%

17

15

Visa (NYSE: V)

49%

41

20

Baidu.com (Nasdaq: BIDU)

77% Continued...