×

Putting Earnings Reports In Context

It’s important investors put a company’s earnings report in context, Cramer said Thursday. The “Mad Money” host detailed just how he interprets an earnings report.

To start, Cramer looks at the predictive value for the year. If a company issues a report that beats the high man (the analyst who has the most aggressively high estimates on Wall Street), then that beat will cause a raising of numbers for the rest of the year.

If a company does post such an increase in earnings per share, Cramer will try to figure out whether it actually stemmed from real business or had occurred as a result of accounting changes. To make that analysis, Cramer looks more at the revenues than the actual earnings themselves because a company can’t change the sales line except by increasing demand, taking market share or by just plain better salesmanship.

A company can, however, change the earnings by buying back a ton of stock. So the number of shares changes, but the profits stay the same. Investors should look at the accelerated revenue growth quarter-to-quarter and year-over-year because it tells you a lot about future revenue and earnings growth, helping you figure out how much to pay for a stock.

“Figure out what that growth rate is using the revenue and earnings prism I have just given you, figure out how fast it is growing both linked quarter—the previous quarter and the current one—and year over year and then calculate that trajectory versus the growth rate,” Cramer said. “If a company is growing at 20 percent and the price-to-earnings multiple, the stock price divided by the earnings per share, is 20 or less, you probably have a big bargain on your hands.”

Cramer refers to this concept as the price-to-earnings growth ratio. To him, it’s much more important than the price-to-earnings multiple because it puts the multiple into context.

“As a rule of thumb I am willing to pay for a price to earnings multiple that may be up to twice the growth rate of the company, especially if there are very few companies growing that fast, meaning there is a scarcity value of fast growing companies,” Cramer said. “Higher than that, paying 24 times earnings for a company that is growing at 40%, begins to get me nervous, even if 40 percent growth is very hard to come by.”

Call Cramer: 1-800-743-CNBC

Questions for Cramer? madmoney@cnbc.com

Questions, comments, suggestions for the Mad Money website? madcap@cnbc.com