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As stock valuations rise each day, Jim Cramer says investors need to figure out what they can handle in the market. He compared Amazon, Facebook and Microsoft to explain the concept of risk and reward amid elevated prices.
"As we go higher and higher, the risks grow and you need to know not just the rewards but what can go wrong after this historic run," the "Mad Money " host said.
Cramer chose these three stocks because they are well-known, and provide insight on the different ways that stocks can be valued in an overheated market.
The cheapest of the three is Microsoft, which reported a very strong quarter on Tuesday. It is transforming itself from a software company focused on PCs to be a large provider of cloud. With a growth rate of approximately 7 percent and the stock selling at 19 times earnings, Cramer noted that it is actually cheaper than the average stock in the right now.
"In an era where there are precious few ways to get decent income, Microsoft, after this incredible quarter, represents a very strong opportunity," Cramer said.
The reason why it's still so cheap? Because of its history, Cramer said. For a long time the company was perceived as a boring one with a product that was becoming outdated. Its previous CEO Steve Ballmer made a series of bad bets, including when the company purchased Nokia's phone business for $7.2 billion. Cramer thinks it was "one of the most boneheaded acquisitions in history."
"They would have done better if they just set that cash on fire, like the spoils from the Armenian money-train heist," Cramer said of Microsoft's decision.
Facebook hit an all-time high on Wednesday when it confirmed that its messenger service now has 1 billion users, with 200 million new users since the beginning of the year.
The stock seemed expensive to Cramer at 31 times earnings, but he thinks the growth rate is actually accelerating, even with a 31 percent monster growth rate. That actually makes it cheap in Cramer's perspective, because growth stocks tend to trade between one or two times their growth rates and Facebook is at the bottom of the range.
"I pronounce Facebook as being relatively inexpensive versus a ton of other growth stocks in this market, suitable for those individuals willing to take on some risk in order to get a lot more reward than stock like Microsoft can offer," Cramer said.
Then there was Amazon, which doesn't even seem to trade on earnings. Even if Cramer could compute the valuation, he estimated that it trades at 117 times next year's earnings estimates. This one is so difficult because Amazon doesn't play by the rules, he said.
Cramer can easily justify paying $56 for Microsoft or $122 for Facebook. But Amazon? That one could be a different animal from them all, thus Cramer warned it is only for investors who are willing to take on a serious amount of risk.
"You really have to believe that it will do the same thing to every other retail category that it has already done to books and electronics and apparel. You have to believe Amazon will destroy the mall," Cramer said.
Amazon could be a leap of faith, but Cramer advised that a lot more things have to go right for the stock to keep climbing, even if history suggests that will happen.