Mad Money

Pro tactics: Cramer reveals strategic buy signal

Cramer's Playbook: Never judge a stock by its $ price
Cramer's Playbook: Never judge a stock by its $ price

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

How does Jim Cramer decide when to pull the trigger on a stock?

Although the "Mad Money" host does considerable research, which includes investigating the pedigree of management, understanding the company's industry position, looking at strength of profit margins and more, one of the most influential metrics he always considers is something called the PEG ratio.

That may sound a little complicated, but Cramer says it's only one calculation away from the P/E ratio, which is likely familiar to most investors.

(For P/E ratio, take the price of a stock, P, and divide by its earnings per share, E. The result equals M, the multiple or price to earnings multiple.)

The widely talked about P/E multiple allows you to compare companies on a relative basis. However the P/E multiple alone isn't enough to draw a conclusion; "there's no price to earnings multiple that's always attractive," Cramer said.

That's where growth enters the equation which ultimately determines PEG.

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Here's how it works.

"You just divide the P/E ratio (or multiple or M) by the long-term growth rate," Cramer said. That's the PEG ratio. That's all there is too it.

And once you determine the PEG ratio, Cramer says you have a metric that allows you to make a decision on somewhat absolute terms.

"My rule of thumb, a guideline that I've arrived at based on more than three decades of trading and investing, is that I don't like to pay more than two times a company's growth rate for a given stock, meaning any stock with a PEG ratio of more than 2 is too pricey for me."

"So if a company has a 10% growth rate, but it's trading at a P/E of 20 or more (that's 20 times earnings), I'm generally inclined to say that's too expensive."

Conversely, I consider any stock that's trading at less than one times its growth rate, meaning it has a PEG ratio of less than one, to be cheap.

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Confused? Here's a telling example?

Priceline sells for 18 times forward earnings, but it has a 19.7% growth rate. Even though shares are over $1000 each, the PEG ratio is less than one.

"It's actually inexpensive," Cramer said with a sly smile, "using this methodology."

And that's how you trade like Jim Cramer.

Call Cramer: 1-800-743-CNBC

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