Why Stocks Aren't As Expensive As You Think
With share prices in the triple-digits, some investors are afraid to own some "terrific stocks" because they think they're too expensive, Cramer said Money. Take shares of Goldman Sachs , Apple , Google , Amazon , Chipotle and Netflix , for example, even though these stocks are cheap relative to earnings.
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That's why Cramer would like to see ten-for-one splits for these stocks, even though splits create no value.
"Their share prices terrify people," Cramer explained, adding that while it feels daunting to buy Goldman at $155 a share, the stock would likely go higher if an investor had to pay just $15.50.
The share price, however, tells an investor little about the value of a stock. It's the price earnings multiples that tells you how much the market's willing to pay for a company's earnings per share. This is computed by the price, P, equals the earnings per share, E, times the multiple, M. Apple, for example, trading at $262 when it's expected to earn $17.47 next year is no different than $26 a share and expected to earn $1.74.
"But emotionally these hundred-plus dollar stocks scare the bejeesus out of people," Cramer said. "The idea of losing $10 on a $262 stock is a lot more frightening than losing $1 on a $26 stock, especially in an age of high frequency trading, even though objectively there's no difference. They're both 3.8% declines."
To comprehend how expensive a stock is, Cramer recommends dividing a stock by ten. By thinking of the stock as a tenth as expensive with a tenth of the earnings, it is easy to see how cheap the stock really is. With a ten-for-one split, investors would see just how cheap these stocks really are. As people started buying these stocks, they would likely push higher with a higher multiple and growth rate.
While Cramer hopes for a ten-for-one split, he doesn't think it will happen. If that's the case, he recommends stock replacement, where you can use deep in the money call options to capture the appreciation of a company for less than you'd pay for the common stock. At the same time, Cramer said this play would eliminate your downside.
A call option gives you the right, but not the obligation to buy 100 shares of a stock at a given price (the strike price) within a given timeframe. When you buy a call option, you're trying to control the appreciation in a stock above the strike price and you want to capture the greatest percentage gains while taking on the least risk. Most people buy what are called out-of-the-money call options, which are options where the strike price is higher than the current share price. This is how most people play options.
Cramer, on the other hand, uses his stock replacement strategy because it essentially uses options to replace or create new stock in a form that lets you control your downside and gives you much more upside than owning ordinary common stock. He recommends deep-in-the-money calls, which are call options that let you buy a stock at a price that's much lower than the one where it's currently trading. The benefit of paying more is even if the stock falls, you don't get wiped out. Instead, you as the investor can define the downside and you start profiting as soon as the stock goes above a certain level.
You've got an investment that moves with the stock. This strategy does require timing and close attention, Cramer said, because it happens quickly.
"I urge you to try using deep in the money call options as stock replacement," Cramer said. "Please, please, if you do buy the common stocks, remember they aren't expensive, they are just high dollar amounts, and if you mentally divide by ten, you will be far less frightened when they inevitably go against you."
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