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 MaximumProfits .

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

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 Employment

So 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.)

Put a PEG on It

The best way to make the P/E ratio truly useful is to consider it in tandemwith the company's growth rate.

Enter the PEG ratio -- the "price/earnings to growth" ratio.

It's just the P/E ratio divided by the company's annual earnings growth rate, and that is why the PEG ratio can be a much better indicator, says Bernstein. "It looks forward and can tell you if the business has been solid," he says.

The basic rule of thumb is that if the PEG is below 1, the stock is underpriced. If PEG is greater than 1, the stock is overpriced. If a company's PEG is 1, the company is pretty fairly valued. Take Citigroup ( C). Its PEG is around 1.1, and its P/E is 10 vs. the industry's 13. No wonder Cramer calls the stock "best of breed."

Or better yet, on Wednesday Cramer pointed to MasterCard ( MA) with its 15 P/E ratio on 20% growth. "Shouldn't that be the reverse?!?" he yelled. He meant that with 20% growth, he'd buy it if it had a P/E of up to 40. And with a PEG ratio of 0.88, he sees the stock as clearly undervalued.

So now you decide if the P/E ratio can be the king of your domain. It certainly can tell you a lot about a company if you use earnings growth rates in your analyses and then compare the ratio with those of other stocks in the same industry. But don't let the P/E ratio make or break your decision. Make sure you understand your company's fundamentals and the current market environment

It's just as in beer. Sam Adams Summer Ale is perfect for this time of year. But when the fall comes, you can't beat Sierra Nevada's Harvest Ale. The changing environment makes a big difference in what truly is the king.

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Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback; click here to send her an email.

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