Whenis a stock's priceconsideredlow? $10 a share? $100? There's noperfectanswertothesequestions, buttherearewaystoatleastgaugehowexpensiveorcheap a stockis.

Yousee, byusingsomethingcalled a multiple, wecanfigureouthowmuchwe'repayingfor a stock's underlyingbusiness, andifthispricehaschangedovertime.

YoumayhavenoticedthatwhenyouGooglesearch a stock, like, well, Googleforexample, youendupwith a seriesofsearchresults, aswellassomebasicdetailsabouttheticker.

The P-E isanexampleofwhat's called a multiple, a ratiothatcompares a stock's pricetosomefundamentalnumber. Generallyspeaking, thehigherthemultiple, themoreexpensive a stockisconsidered. Thinkofitaslike a priceperpoundat a butchershop.

Multiplesworkin a similarway, allowingustocomparethepriceof a stocktotheunderlyingfundamentalsyougetwiththepurchase. Now, therearehundredsofdifferentmultiplesthatinvestorscanuse, includingtheEVtoEBITDA, pricetobookvalue, etc, etc.

Someofthemultiplesareindustry-specific, whereasothersaremorebroadinnature, andeachcarries a differentimplication. Butthe P-E ratio, whichstandsfortheprice-to-earningsratio, isoneofthemoststraightforwardandpopular.

It's easyenoughtocalculate, sinceyoutakethestock's priceanddivideitbythecompany's earningspershare. Forexample, ifPlainBagelCo. had 1 millionsharesoutstanding, eachofwhichweretradingat a priceof $30, andlastyeartheirnetincomewas $2 million, thestock's P-E ratiowouldbe 15 times. This P-E ratioisknownas a trailing P-E, becausewe'recalculatingitusinghistoricalinformation, andit's oneoftheeasiestmultiplestounderstand. Itbasicallyrepresentshowmuchaninvestoriswillingtopayperdollarof a company's profits. SoforPlainBagelCo., wearepaying a priceequalto 15 timesourshareofthecompany's profit. Sothetrailing P-E helpsconceptualizehowmuchwe'repayingfor a stock, butitdoeshaveitsshortcomings. Thebiggestonebeingthatitisbackwards-looking, whereasmanybelievethatmarketsareforward-looking. If a companyisexpectedtorelease a newproduct, enter a newmarket, orimproveitsoperationsinthefuture, then a stockwilllikelytradehigher, somethingthatthetrailing P-E wouldn't takeintoaccountusingpastearningstoexplainthestock's currentprice. Becauseofthis, manyinvestorspreferinsteadtousewhat's knownas a forwardmultiple, inthiscasetheforward P-E, whichdivides a stock's pricebyhowmuchthecompanyisexpectedtomakenextyear.

Forexample, let's saythatPlainBagelCo. isexpectedtolaunch a newbagelproductnextyear, andas a result, analystsareexpectingearningstoincreaseto $2.5 millionnextyear.

Inthiscase, assumingeverythingelseremainsunchanged, PlainBagelCo.'s forward P-E multiplewouldequal 12 times. Now, theclearproblemwithforwardmultiplesisthattheyrelyonforecasts, whichmaynotpanout, buttheycanstillhelpgaugethevalueof a stockandhowmuchinvestorsarepayingupfor a company's potentialprofit. SoforPlainBagelCo., ourforward-looking P-E is 12 times. Great, butwhatdoesthatmean? Well, byitself, not a wholelot. Yousee, multiplesare a relativemeasure. Sure, understandinghowlongitwilltakeforyourstocktopayforitselfisuseful, buttounderstandwhetherthelevelisattractiveornot, we'vegottocompareittoothermultiples. Wecould, forexample, comparethe P-E ratiotoPlainBagelCo.'s historical P-E ratiostoseehowithaschangedovertime. Thiswouldgiveusanideaofwhetherinvestorsarevaluingthecompanyhigherorlowerthannormal.

Wecouldalsocomparethe P-E multipletothestock's long-termaveragetoseewhetherthemarginislargerorsmallerthannormal. Ifthestock's 10-yearaverage P-E is 15 times, wecouldassumethatthestock's multipleistemporarilycheaperthannormal, andmaywarrant a buy. Ifwepickupthestockandthemultiplelaterexpandsbacktoitslong-termaverage, thenwecouldearn a return, evenifthecompany's earningsareflat.

A keyassumptionhereisthat a multipleisexpectedtoreverttoitsmeanovertime.

Andwhilethatdoesn't alwaysholdtrue, investorssometimeslookforextremevariationsfromthemean, withmanybelievingthatshort-termvolatilityin a stock's multiple, whichcouldbecausedby a badpressreleaseornegativenear-termheadwind, willeventuallysubside, causingthemultipletoreturntoitsnormallevel, assumingthecompany's corebusinessremainsunchanged. Awesome, soif I find a companythat's tradingat a multiplebelowitshistoricalaverage, I'm goodtobuy, right? Well, notquite. Sure, understandingwherethecompany's stockvaluestandsrelativetoitspastisgreat, butyouneedtocomparethevaluetootherstocksaswell, inthesameindustry. Inouranalogy, ifyoufoundporkonsalefor $6 a pound, itmaystillbetooexpensiveif a butcherdowntheroadisofferingporkfor a regularpriceof $2.50 a pound. Similarly, weneedtogaugethevalueof a stockrelativetoitspeers.

So, let's takePlainBagelCo. andcompareittoSesameSandsandTheHaggleBagel, whicharetradingat 4 PEsof 13x and 7x, respectively. IfyoucomparePlainBagelCo.'s 12x multipletoitspeeraverageof 10x, well, thenwecanseethatthestockisactuallymoreexpensivethanotherbagelcompaniesonaverage. Alright, sothestockischeaperthanitnormallyis, butmoreexpensivethanitspeers, soshould I buyorsellorwhat? Well, asgreatasitwouldbetohave a one-numberbasisformakinginvestmentdecisions, it's simplynotthatsimple.

Theyareprettymeaninglesswithoutcontext, andchasinglowmultipleswithoutanunderstandingof a company's corebusinessandfutureprospectsmayleaveyouwithsomethingcalled a valuetrap.

A stockthatlookscheapcomparedtoitshistoricalprices, butcontinuestofallevenfurtherbecauseof a deteriorationinthefirm's fundamentals. So, whydiscussmultiplesiftheycouldmeanthat a stockisbothoverandundervalued? Well, it's notthatmultiplesareuseless.

Theyare a handywaytoquicklyunderstand a stock's pricelevel. But, as I saidatthebeginning, theyare a roughgaugeof a stock's valueatbest. SomeinvestorsevencontestthatthePEmultipleisincrediblylimitedbecauseofitsuseofaccountingearningsnumbers, whichmaybeeasilyalteredbymanagementassumptionsandnon-cashitems. So, whilemultiplescancertainlyhelpyoumakeinvestmentdecisions, youneedtoensurethatyourdecisionisbasedon a thoroughunderstandingof a firm's operationsandfutureprospects, notjustthestock's multiple. A goodapproachistofindcompaniesyoulikebasedontheirfundamentals, andthenfindsomeappropriatemultipletounderstandthefirm's valuationafterthefact. Lookingforcheapstocksfirstmayleaveyouwith a portfoliooflow-qualityholdings. Afterall, asWarrenBuffettsays, it's farbettertobuy a wonderfulcompanyat a fairpricethan a faircompanyat a wonderfulprice. So, nexttimeyoufind a stocktradingat a lowmultipleor a stakesellingat $3 a pound, makesuretocheckthefundamentals, andthestake's expiration, andthatthestakeisactually a stake. But, withthatsaid, we'reoutoftime.