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 dangeroustool, 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 General Electric (NYSE: GE) earned $1.28 per share over the past year. At today's price of $16.60, its P/E ratio is $16.60 / $1.28 = 13. You might also hear the hip Wall Street crowd say "GE has a multiple of 13" -- because it soundsso 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 $8.30 per share for GE for its $1.28 in earnings (P/E = 6.5) than $16.60 (P/E = 13), right?

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

What it isn't
Of course, things are neverequal 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 Monsanto (NYSE: MON) is trading at a P/E of 20. The wonderfully named Potash Corp. of Saskatchewan (NYSE: POT) has a multiple of 11. So Potash must be a better value, right?

Well ... maybe. It's rare to find two businesses that are exactly alike, and these two, while in the same industry, certainly have many differences. Also, what about earnings in the years ahead? If Monsanto is able to rake in more cash than PotashCorp. 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 picture the P/E provides.

The "forward P/E" published by some sources is a better tool, because it uses the nextyear'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.

Company

Estimated 2-Year Growth Rate

Trailing P/E

Forward P/E*

Newmont Mining (NYSE: NEM)

36%

37

19

Intel (Nasdaq: INTC)

33%

45

17

EMC (NYSE: EMC)

34%

31

18

priceline.com (Nasdaq: PCLN)

49%

35

21

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