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
P/E: Please ExplainTo 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
Cramer generally uses the "estimated" P/E, which is based on the company's current fiscal year, as opposed to last year's trailing numbers. So, it's as close to a current P/E as you're probably going to get. Still, some pros actually like to look at a "projected P/E," which is then based on future earnings. But that just means a bunch of guessing has to go into the calculation, and the last time I checked, the ol' crystal ball was worthless. So read those numbers prudently.
Proper EmploymentSo what does the P/E ratio tell you? It's basically the price an investor is willing to pay for $1 of the company's earnings. So in our example, with a P/E of 10, investors are willing to pay $10 for every $1 of earnings that the company generates. But that means nothing if you don't compare that number with those of your company's peers. Clearly, different industries have different "normal" P/E ranges. For example, the Internet providers such as Google ( GOOG) and Yahoo! ( YHOO) have an industry average P/E of about 50, while the financial stocks' average P/E hovers around 13. That means people are willing to pay more for the Internet stocks because they're still expecting big growth. Same goes for the health care sector. On the flip side, the financials are on the slow-and-steady path and are therefore less exciting, so people aren't willing to pay as much. But note: A company with a high P/E ratio -- meaning high growth expectations -- eventually has to live up to the hype. Take Microsoft ( MSFT). Back in the go-go days, its P/E was around 100. That's because people expected the company to rocket. And it did. But now that its hot-new-company momentum is over and it's turned into, dare I say, a boring blue chip, its P/E is down to 18. (Nothing wrong with boring, though. Boring pays the bills.)