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As scary as it might sound, you can graduate college with a degree in economics and not even know how to balance a checkbook. Jim Cramer is completely horrified by this, which is why he knows that an education with the basics of investing is a rare occurrence.
The reality is that money is really important. It can ruin your life and relationships at the drop of a hat. Or even the drop of a stock valuation.
Speaking of which, what the heck does valuation mean? How do you know the difference between something that is cheap or expensive? Professor Cramer is here to explain.
First, never judge a stock by its dollar price. Judge it only by its price-to-earnings multiple, also called its P/E.
Don't worry—you don't need a fancy college degree, or even know how to do math. Simple elementary school arithmetic will allow you to calculate the P/E.
The price of a stock (P), divided by its earnings per share (E), equals the price-to-earnings multiple (M).
Valuations are all about the future, not the past. That is why Cramer always looks at the earnings estimates for next year when he evaluates a company.
The reason to use the price-to-earnings multiple is that it will provides an apples-to-apples view when comparing different stocks to each other.
But let's also remember that growth is really important, since valuation is about the future. That is why Cramer said that you always, always, always have to factor in the growth rate to the multiple. That's why there is a PEG (Price/Earnings to Growth) ratio.
Don't freak out, it's not complicated. This is the number that compares the price-to-earnings multiple to the growth rate for you. Just divide the multiple by the long-term growth rate.
"My rule of thumb…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 pricey."
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On the other hand, Cramer thinks that a stock that is trading at a PEG ratio of less than one is cheap. When you see a high quality company selling than one time it's growth rate, you might have a great opportunity to buy, buy, buy.
If you are new to the game and you're not sure what all the numbers mean, just remember that the price-to-earnings multiple will make it easier to compare stocks so you're dealing with apples to apples. This way you can value them in relation to one another, and not get lost in the big sea of stocks.