- "You need to know the vocabulary before you can evaluate a stock," CNBC's Jim Cramer says.
- "When you're comparing, look at the price-to-earnings multiple … the growth rate, the top line, the bottom line and the gross margin when you're trying to figure out which stocks are worth owning," the "Mad Money" host says.
When investors consider stocks to purchase, there are more things to consider than just a security's sticker price.
"You need to know the vocabulary before you can evaluate a stock," "Mad Money" host Jim Cramer said. "When you're comparing, look at the price-to-earnings multiple ... the growth rate, the top line, the bottom line and the gross margin when you're trying to figure out which stocks are worth owning and which stocks are worth" selling.
Buying a stock is all about paying for a share of the underlying company's future profits and growth. In order to value a particular stock, investors must examine where the stock is trading relative to its earnings per share, also known as EPS. That's known as finding the price-to-earnings multiple, stylized as "P/E multiple," which is the "cornerstone" of valuing stocks that lets investors make an "apples-to-apples comparison" of stocks, Cramer explained.
A simple equation can reveal the multiple: the multiple (M) equals share price (P) divided by earnings per share (E), or M = P/E.
"The multiple tells you how much investors are willing to pay for a company's earnings," Cramer said. "It's the most basic form of valuation analysis: A stock that sells for 20 times earnings is cheaper than a stock that sells for 25 times earnings."
Growth rate measures how much a company's profits improve on an annual basis. Due to demand, stocks of companies that are expanding faster tend to carry higher multiples, Cramer said. The multiple determines what investors are willing to pay for those profits, or earnings, he added.
For example, if Chipotle shares trade at more than 40 times earnings, it doesn't make it more expensive than slow-but-steady growers such as PepsiCo trading at, say, 22 times earnings, the CNBC host said.
"Chipotle deserves the bigger price-to-earnings multiple because it has a much, much higher growth rate," he said.
Company profits, also called net income or earnings, is commonly referred to as the bottom line. It's the number at the bottom of the firm's income statement — what's left over after all bills, taxes and other expenses are paid.
This differs from the top line, the line on the income statement that sums up all the money that flows into the company's accounts — revenues or sales.
"You want to see strong revenue growth, which tells you there's demand for a company's product. This is ultimately the key to sustainable, long-term earnings growth, and that's why it's especially important for younger, smaller companies to have fast-growing revenues," Cramer said. "Oh, and investors will really pay up for accelerating revenue growth," known as ARG, "which means the sales are rising at a faster and faster rate."
Gross margin is "super important" to determine how much profit a company is able to yield, Cramer said. The figure is the percentage of every dollar of sales the company retains after subtracting the cost of products sold.
"To get a sense of where the gross margin might be headed, you have to consider the competition, the cost of production [and] the cost of doing business in general. Businesses with cutthroat competition like supermarkets or the airlines ... tend to have really terrible margins," while a company with little competition such as Microsoft has margins that "some people think are downright obese."
Disclosure: Cramer's charitable trust owns shares of Microsoft.