Cramer: When Is a Stock a Growth Stock?

You always hear that the market values growth above all else.

The idea is that these so-called growth companies will command big premiums with investors willing to pay more for the promise of future returns.

But how can you tell if a stock is, in fact, a growth stock.

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Use basic algebra, says Cramer - that's how to tell.

Here's how to do it:

"The share price, P, equals the earnings per share, E, times what's known as the multiple, M," Cramer said

In other words, "E times M equals P.

"The multiple is the key, it tells us what investors are willing to fork over for a company's future earnings. And the most important factor influencing multiple is the company's growth rate. The Street will pay a bigger multiple for businesses with faster growth because that growth means the earnings will get larger and larger in the years ahead."

Businessman stock charts tablet
Yunus Arakon | E+ | Getty Images

Now as you're attempting to determine if you're a buyer or not - Cramer said apply this simple rule.

"A stock can trade up to a multiple that's as high as twice the long-term growth rate before it gets too expensive for me," he said.

That means if a company is growing its earnings per share at a 20% clip, its stock could potentially trade as high as 40 times earnings and Cramer would still be a buyer.

However, if you hold a growth stock, Cramer says it's important to do constant homework.

"You need to watch, like a hawk, the direction the earnings estimates are going," he said, "and whether those estimates are increasing at a faster or slower pace."

As long as they're increasing at a faster rate, the market will pay the premium for the growth.

But - when they start to slow, the Street will turn it's back.

"When that happens and it always happens - that is, when growth begins to decelerate, then the stock could go SPLAT! It's like driving a fast car right into a brick wall."

In other words, the moment a growth company stumbles the stock can fall faster than you could imagine.

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Chipotle may be a good example, a darling of growth investors, it dropped more than a hundred points, losing a quarter of its value in a matter of days, when, in July of 2012, it reported a disappointing quarter that suggested the company might be more vulnerable to economic weakness than previously thought.

Despite the risk, Cramer thinks growth stocks are worth the reward. Often times when the market swoons, growth stocks will perform relatively well, because investors are still winning to pay up for growth.

"I feel strongly that to build a portfolio that can work in every kind of market, you need a growth stock in the mix," Cramer said.

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