An explanation of how Wall Street professionals value stocks could take all night, but Cramer has a simple rule of thumb that any home-gamer can use.
Remember that E, the earnings, multiplied by M, the multiple, equals P, the price. That’s the price-to-earnings multiple. If a stock’s PE multiple is equal to or less than its growth rate, then that’s a cheap stock, Cramer said.
A stock with a PE that’s twice the growth rate follows the opposite logic: Ten percent growth on a 20 multiple stock probably means it is time to take profits.
Cramer learned this rule through hard-won experience. He knows that value investors are attracted to stocks close to their growth rate, which creates a floor. On the high end, growth investors rarely pay more than twice the growth rate, which creates a ceiling. Now the stockholder has a range for selling his wares.
It’s good to hunt for value among stocks with PEs that are about one times the growth, but be careful not buy damaged goods. Plenty of inexpensive-looking stocks are actually quite pricey if the fundamentals are declining and the earnings are going to miss the estimates, Cramer said.
Again, the opposite is true. A stock that’s trading with a multiple that is twice its growth rate looks expensive. But if its earnings need to be revised higher, its multiple will come down and it has more room to run.
Bottom Line: When you value stocks, anything with a multiple that’s lower than the growth rate should be presumed cheap. Anything with a multiple that’s more than twice the growth rate is expensive.
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