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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)Thornburg Value 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.

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