A common tool investors use to evaluate a stock is a P-E ratio. The P-E ratio is a company's stock price divided by the 12-month earnings per share. For example, a company with earnings of $2 per share over the last 12 months and a stock price of $30 per share would have a price-earnings ratio of 15.

The best way to interpret a P-E ratio is as a popularity index. Stocks that are popular with investors sport high P-E ratios, while those that are in the doldrums usually carry lower P-E ratios. A company experiencing rapid earnings growth usually has a much higher P-E ratio than a company in a cyclical industry whose earnings have been volatile.

A number of studies suggest that stocks with low P-E ratios have some ability to outperform the market. The logic is that these stocks already discount the worst, and any positive earnings surprises drive them sharply higher. Conversely, stocks with high P-E ratios reflect high expectations and are vulnerable to sharp sell-offs should results come in below Wall Street's expectations.

I think the best way to use a P-E ratio is relative to the market and its historical range. For example, a stock with a P-E ratio that is usually above the market average but that has recently dipped below the market average may be a potential turnaround play. Also, a stock that normally trades with a P-E ratio at a 30 percent premium to the market P-E ratio but now is only at a 5 percent premium may signal a buying opportunity.

One rule of thumb many investors use is never to invest in an issue whose earnings growth rate does not match or exceed the P-E ratio. According to this thinking, a company with a 40 percent earnings growth rate could support a stock with a P-E ratio of 40 or under; a company with a 10 percent growth rate would be considered overvalued if its stock's P-E ratio was 20.