Cramer's 'Mad Money' Recap: Tools of Cramer's Trade
"If a stock has a price-to-earnings multiple -- remember E (the earnings) times M (the multiple) equals P (the price) -- that's lower than its growth rate, then that stock is cheap," Cramer said.
"If a company has 10% growth but trades at eight times earnings, this rule says it's cheap. If it has 10% growth and trades at 10 times earnings, it's still dirt cheap."
However, a stock with 10% growth and a 20 multiple is a stock that market players should take profits in, he said. Any stock with a multiple that's more than twice its growth rate is too expensive.At the same time, Cramer warned viewers that like any of his methods, this one is a rough approximation. "It's useful, but it's not always right," he said. "A lot of times a stock will get cheap, based on its earnings estimates, because those estimates need to be cut." "Plenty of inexpensive-looking stocks are actually quite pricey if the fundamentals are declining, and the earnings are going to miss the estimates," Cramer explained. "It's the same at the top of the price range, but less dangerous: A stock that's trading with a multiple that's 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," he said. While the market is "too dynamic" for there to be any hard and fast rules to define how the growth affects a stock's price, there are some important points that come out of the connection, he continued. "The most important is that stocks with accelerating growth, be it sales growth or earnings growth, are worth more than stocks with decelerating growth."
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