CNBC's Jim Cramer told investors it's important to understand the basic terminology used to describe a company's value, including a price-to-earnings multiple.
The price-to-earnings multiple, also referred to as a P/E multiple or just a multiple, is the ratio of a company's share price to its earnings per share. This multiple is used to determine how much investors are willing to pay for a company's stock in relation to its earnings.
Share price alone is not enough to determine a stock's value, Cramer said. When investors talk about a stock being expensive, they're often referring to the multiple, he said.
"Price-to-earnings multiples aren't static. In different markets, people will pay more or less for the same amount of earnings," he said. "When they pay more, we call that multiple expansion, and when they pay less it's called multiple contraction — two more terms that sound much more complicated than they really are."
Cramer also defined other terms used to measure a company's profitability. For example, a company's top line refers to its revenue, while the bottom line refers to its net income. Gross margins tell investors what's left after subtracting the cost of goods sold from its revenue.
"You need to know the vocabulary before you can evaluate a stock," Cramer said. "I know this might sound basic to many of you, but I'm here to educate people, and I don't want anybody trying to pick stocks without a firm understanding of the basics."
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