Mad Money

Wall Street lexicon you simply must know

Know the price to earnings multiple: Cramer

(The video above was first made available on Aug., 30, 2013. Click to go to a searchable transcript of this Mad Money segment)

Sometimes it feels like Wall Street speaks its own language. If you're new to the market, Jim Cramer says there's one term you absolutely must understand before trading stock.

That term is P/E ratio.

"That's the price to earnings multiple, or P/E multiple, or just the multiple; they all refer to the same thing, and the concept is the cornerstone of how we value stocks," Cramer said.

Unfortunately, all too many new investors don't understand that. And if you're among them, it could cost you big.

That's because if you don't understand P/E multiples, Cramer worries that you'd be inclined to look at the dollar amount of one stock and compare it to the dollar amount of another stock and erroneously conclude that's what pros mean when they talk about a stock being cheap or a bargain.


Adam Jeffery | CNBC

"When you hear a pro talk about how some stock is a bargain he or she is talking about the P/E ratio," Cramer said, which is determined by the following formula; share price P, equals the earnings per share, E, times the multiple, M.

Therefore, when you hear someone say that PepsiCo is cheaper than Coca-Cola, they mean Coke sells for 20 times earnings and Pepsi sells for 18 times earnings.

And that matters considerably to pros because it shows how much of a premium a stock is commanding relative to peers.

If the value seems appropriate given market conditions and other variables, then pros consider the stock fairly valued. If not, that is, if the premium is too great or the stock is overbought, pros will often bet on a decline. Conversely if they believe the premium is too small or the stock is oversold, pros will often bet on an increase.

"Now here's where it gets interesting," Cramer added, "multiples aren't static. In different markets people will pay more or less for the same stock.

When the economy is uncertain, the multiples for defensive stocks such as General Foods, Altria and Kimberly Clark may command a greater premium because these companies make products that consumers are still likely to buy in a downturn.

Conversely, when the economy is robust, cyclicals such as Caterpillar, Ingersoll-Rand and Dow Chemical are more likely to command a higher multiple because they profit during times of expansion.

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What's the bottom line?

Understanding P/E ratios is the cornerstone of informed investing. The better you understand this concept, the greater your chances of generating profits from the stock market.

*Editor's Note: This "Mad Money" segment first aired on Friday August 30, 2013 and the video above is from that time.

Call Cramer: 1-800-743-CNBC

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