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.
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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 percent, begins to get me nervous, even if 40 percent growth is very hard to come by.”
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