Calculating a Stock’s Risk-Reward Ratio

Focusing on a stock’s upside without giving proper consideration to potential losses, said Jim Cramer on CNBC's "Mad Money," can be “a grave mistake.” Too often people think only of the reward, without assessing the risk. And investors must calculate both.

Jim Cramer
Jim Cramer

“Because the pain from a big loss,” Cramer said, “hurts a whole lot more than the pleasure from an equivalent-sized gain.”

But how do you figure out the risk-reward on a stock? As a general rule, Cramer looks at the lowest price that a value-oriented money manager would pay for that stock to calculate the downside. For the upside, he uses the most a growth-focused manager would pay.

(RELATED: Cramer's Top Dividend Stocks)

To arrive at these numbers, Cramer refers to something called “growth at a reasonable price,” or GARP, a method of stock analyzing first popularized by Peter Lynch. If you want to know just how much growth investors will pay, you need to understand GARP. And it involves a comparison of a stock’s growth rate to its price-to-earnings multiple.

But you can use this rule of thumb to figure out the value side of the equation, too, and here’s how Cramer does it: If a stock has a price-to-earnings multiple (PE) that’s lower than its growth rate, it’s probably cheap. And any stock that’s selling at a multiple that is twice the size of its growth rate or greater is probably too expensive and should be sold.

Example: A stock trading at 20 times earnings with only a 10 percent growth rate would be considered expensive. But the reverse — 10 times earnings on a 20 percent growth rate — would be incredibly cheap.

This gives rise to another piece of Wall Street jargon: the PE-to-growth ratio, or PEG, which is the multiple divided by the stock’s long-term growth rate. A PEG of one or less is “extremely cheap,” Cramer said, while a PEG of two or more is “prohibitively expensive.”

This means then that the risk floor created by value investors will probably be somewhere near a stock’s PEG of one, while its ceiling, created by growth investors, rarely exceeds a PEG of two. That’s why Google back between 2004 and 2007 was considered cheap, because its 30 percent long-term growth rate matched its 30 multiple. But if that multiple reached 60, growth managers would probably cash out of their positions.

There is one caveat to keep in mind, that this is a general rule of thumb, an approximation. But there are times when the numbers can be wrong. Cramer said stocks can look cheap based on earnings when those earnings estimates need to be cut, much like the banks and brokers were ahead of the 2008 crash. Or a stock could look cheap because its growth is slowing, like Dell after the dot-com collapse between 2000 and 2003. In these cases, the stock could trade well below a PEG of one, but that obviously doesn’t mean it’s a buy.

One final anomaly of multiples regards industrial companies, or cyclical names in general. The time to buy these stocks is when their multiples look outrageously high, Cramer said, because the earnings estimates are too low and read to be raised to catch up with their strengthening businesses.

(Written by Tom Brennan; Edited by Drew Sandholm)

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