This Day On The Street
Continue to site
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

Booyah Breakdown: The Ratio King

Editor's note: Welcome to "Booyah Breakdown," an explanation of certain terms and topics Jim Cramer discusses on his "Mad Money" TV show. Feel free to ask a question if you're confused about something Cramer talks about, but please keep in mind that we do not provide advice on specific stocks.

How did Budweiser become the king of beers?

I certainly don't think it's "king." I'm a Miller Lite girl. But apparently Bud had enough cheerleaders -- or drunken fraternity boys -- out there to grant it that title.

Well, the same cheering squad must've been in high force when the price-to-earnings ratio surfaced.

Many believe that price-to-earnings is the king of the ratios, arguing that it's the simplest way to measure how expensive a company's stock is. "If you're going to use just one metric, P/E is probably the one to go with," says Connor Browne, co-manger of the (TVAFX) fund.

And Jim Cramer mentions it on "Mad Money" constantly, saying he won't buy a company that has a P/E is more than two times its growth rate. So, if a company's growth rate is 30%, its P/E better be below 60, or he's not going near it.

But while Jim often refers to P/E, we all know it's not the only king in his castle. He always looks at the company's fundamentals and the current market environment when making a buy/sell decision.

Still, we must pay homage to the P/E ratio. Benjamin Graham, the great value investor and mentor to Warren Buffett, said that the P/E ratio was one of the quickest and easiest ways to determine if a stock is trading on an investment or speculative basis.

Graham was a pretty smart guy. So, let's try to understand what he -- and Cramer -- are talking about.

P/E: Please Explain

To calculate the P/E ratio, divide your company's current stock price by its earnings per share. So, if your company's EPS is $2 and the stock is selling for $20 a share, the P/E ratio is 10 ($20 divided by $2).

Most of the time, P/E is calculated using EPS from the last four quarters, which is why you'll hear it referred to as the "trailing P/E." It's based on the stuff that "trails" behind, a.k.a. historical data. And that's exactly why many will argue that it might not be such a good indication of the future, says Jake Bernstein, founder of trade-futures.com and author of Momentum Stock Selection: Using the Momentum Method for Maximum Profits .

To watch Tracy Byrnes' video take of this column, click here .
1 of 3

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Options Profits

Our options trading pros provide over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • Actionable options commentary and news
  • Real-time trading community
SYM TRADE IT LAST %CHG
C $55.37 -0.56%
GOOG $523.40 0.30%
MA $94.24 -0.28%
MSFT $44.40 -0.10%
YHOO $39.38 0.13%

Markets

DOW 17,730.11 -27.80 -0.16%
S&P 500 2,076.78 -0.64 -0.03%
NASDAQ 5,009.2140 -3.9090 -0.08%

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs