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In messy market, Cramer’s secret ‘buy’ signal

Thursday, 20 Feb 2014 | 6:26 PM ET
Cramer explains 'risk reward'
Friday, 30 Aug 2013 | 6:25 PM ET
Mad Money host Jim Cramer breaks down the parts of the "risk-reward analysis" for investors.

(Click for video linked to a searchable transcript of this Mad Money segment)

Trying to find a stock worth buying right now? Jim Cramer is doing the same thing. And he's got a secret.

The "Mad Money" host believes one of the best ways to find a strategic entry point as well as exit point involves monitoring the market and determining a low water mark, when a preponderance of investors will buy as well as a high water mark, when a preponderance of investors will sell.

That is, "you need to determine where the value guys will start buying on the way down," said Cramer, thinking the stock is just too attractive to pass up." (That's the low water mark.)

Conversely, "you have to think about where even the most bullish of growth guys will start selling," Cramer added, thinking the stock has just gotten too expensive to hold. (That's the high water mark)

By leveraging the buy levels of value investors versus the sell levels of growth investors, Cramer thinks the results will equal something akin to a floor of support and a ceiling of resistance.

To calculate these levels, "I use a quick and dirty rule of thumb that's hardly ever let me down," Cramer said. "If a stock has a multiple that's lower than its growth rate, then that stock is probably too cheap for a value investor to let pass by.

And any stock that's selling at a multiple which is twice the size of its growth rate or greater is probably too expensive, even for an investor seeking growth."

Confused? Here's an example.

Using Cramer's rule, if a stock is trading at 10 times earnings and has a growth rate of 20%, Cramer concludes the stock is cheap – that it will attract buyers – especially those seeking value. (That's because the multiple is lower that its growth rate)

Conversely, if a stock is trading at 20 times earnings, and it has a growth rate of 10%, then Cramer concludes the stock is expensive – that it will attract sellers, even those who bought for growth. (That's because the multiple is twice the size of its growth rate)

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Still with us?

Cramer also uses another ratio, one which he says helps simplify the process.

"I also look at the PEG ratio, that's the price to earnings to growth rate, or the multiple divided by a stock's long-term growth rate. A PEG of 1 or less is extremely cheap, and 2 or higher is prohibitively expensive," he said.

For example, "A high octane super-fast grower like, say, Google in its heyday from 2004 through 2007, could sell for 30 times earnings and still be inexpensive because of it had a 30% plus long-term growth rate, giving it a PEG of just 1, right at the cheap end of the spectrum, and the growth kept accelerating sending the stock to new high after new high," Cramer said.

Also using this system, "When Google still had its mega-growth mojo, with a 30% long-term growth rate, it would have become a sell if it traded up to 60 times earnings," Cramer added.

Of course, no investment strategy is without exception. Exogenous factors ranging from sharply revised GDP expectations to signs of another financial crisis or tech bubble can sideline the strategy all together.

As a result, Cramer advocates employing his 'secret' prudently. However, he also believes at most times, it works and therefore can provide valuable and somewhat quantifiable insights. Just make sure to consider the signals within the context of other market metrics.

Adam Jeffery | CNBC

Call Cramer: 1-800-743-CNBC

Questions for Cramer? madmoney@cnbc.com

Questions, comments, suggestions for the "Mad Money" website? madcap@cnbc.com

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