For example, I once asked a friend of mine, Hiral Patel, who owns a couple of Subway stores how he evaluates an offer for purchasing any new Subway stores if an opportunity came along his way. He answered me: “It’s very simple. I only purchase the store if I can recover my original investment within 3 to 4 years after deducting all the expenses. So, if the store is making pretax $80,000 per year after deducting all the expenses, I prefer to pay between $240,000 and $320,000.”

Investing in the stock market is no different than buying an individual business or store. As most investors do not want to pay more than 3 to 4 times the pretax earnings for the store or the business, it is the general notion for many investors in the stock market not to pay more than 15 times the current earnings for the stock. That means if the company is earning 2 dollars per share in a given year, you don’t want to pay more than $30 per share (2 x 15). There are many other factors that may justify paying a higher or lower P/E ratio than 15 times the earnings per share for any given stock. But, in general, paying 15 times the earnings per share for a given stock is a well-accepted fact on Wall Street.

Interestingly, the Price/Earnings ratio, or P/E ratio, describes how long it will take to recover your original investment in the given stock. So, if the company steadily makes 2 dollars per share year after year without any growth, and you pay $30 per share, then 15 times P/E suggests that it should take 15 years to recover your original investment in the given stock. However,most companies have organic growth between 3 to 8% per year and therefore you should be able to recover your original investment within 6 to 8 years if you have paid 15 times the current earnings to acquire a share to begin with. So, the next time you see high price to earnings multiples such as 40 times P/E or 50 times P/E, zip up your wallet and think twice before investing.

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