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My friend Dave thinks Google is massively overpriced: $530 (U.S.) to buy a single share.

What he doesn't understand, despite having been in the stock market for years, is that the price of a share isn't relevant on its own: It's what you get for the money. With Google, you received almost $20 in earnings in 2009 for each share you owned. That may not sound like much if you paid more than $500 for it, but you have to account for the fact that those earnings are growing fast: 50% last year alone.

All these moving parts are reflected in a stock's price-to-earnings ratio, which is the true way to gauge how expensive it is. Google would cost you about 26 times earnings-that's the P/E ratio. Put another way, if the earnings didn't grow, it would take you 26 years to get your money back. But of course those profits will rise briskly-for a while, anyway-so it won't take nearly that long. Google might be cheap. It's hard to know for sure.

So, are stocks expensive in general? The S&P 500 is quoted at about 15 times forward earnings, well below its long-term average of a little more than 19 times. That discount shouldn't exist when interest rates are so low that money is practically free. The reason investors aren't paying more for stocks is likely that the earnings forecasts are too unreliable or they foresee lacklustre economic growth.

Within that index, though, some stocks are quoted at very high multiples. Amazon is at 58, prompting some pundits to say it's overvalued. Yet, as I write this, the market is down and Amazon is up.

The TSX is also home to some big multiples. As of early February, Maple Leaf Foods has a P/E ratio of more than 100. Finning International, which sells Caterpillar machinery, is at 442 times. Avoid, right?

Not so fast. Bear in mind the crucial difference between the two types of P/E ratios. A trailing ratio takes the past year's earnings into the denominator. A forward uses the next 12 months' earnings.

Maple Leaf's trailing number is high because the company took writedowns for a product recall and other problems. But those were unusual losses. The forward number is much more relevant-and it's only 13. Compared to the overall market, that looks great. But we have to look at that other moving part: growth-or lack thereof-in this case. According to analysts, Maple Leaf's sales aren't growing very fast. Hence the low P/E ratio. Nothing comes for free.

Finning is a different story. Its sales and earnings go up and down with the commodities cycle. At the bottom, its earnings are severely depressed, so its P/E ratio soars. But that, of course, is precisely when you want to buy Finning: at the start of a new cycle.

While the P/E ratio is the most important yardstick for investors, it's not always easy to read. It's the price investors are willing to pay for earnings, and that varies from company to company based on a number of factors. Amazon's forward P/E is about 35. Is that high? Not necessarily. It has traded at high multiples in the past and still made people money. You could have bought it for 60 times earnings in 2007. It was less than $40 then. It's $118 today. (That's not to say that it's a bargain either. Investors might be too optimistic about the Kindle, among other things.)

So don't be scared off by high P/Es, and don't lunge at low ones. It's a useful fraction, but its value is in how you use it.

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 28/03/24 4:00pm EDT.

SymbolName% changeLast
FTT-T
Finning Intl
-0.67%39.81
MFI-T
Maple Leaf Foods
-2.8%22.21

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