Jim Cramer on Risk and Reward

The stocks of Amazon, Facebook and Microsoft offer windows to the three ways you can value stocks in this entirely overheated market.
By Jim Cramer ,

Editor's Note: This article was originally published on Real Money at 3:47 p.m. on July 20.

It's all up to you.

That's right. You have to figure out what you want and what you can handle in this market. That's because as we go higher and higher the risks grow and you need to know not just the rewards but what can go wrong after this historic run.

I want to use three examples -- the stocks of Amazon (AMZN) - Get ReportAction Alerts PLUS holding Facebook (FB) - Get Report , and Microsoft (MSFT) - Get Report -- to demonstrate the risk/reward concept that these elevated prices now present for all who want to buy stocks after a big move.

Why these three? Because they truly cover the spectrum of well-known investments and offer you a window to the three different ways you can value stocks in this entirely now-overheated market.

Let's go from cheapest to most expensive.

First, we'll check out the $444 billion software colossus that is Microsoft. This week Microsoft reported a fantastic quarter, much better than the previous one that disappointed many investors. Microsoft is moving from a software company largely for personal computer users to one of the world's largest cloud providers through its fast-growing Azure division, which put up 100% year-over-year growth.

Microsoft, if you look at it statically, is growing at about a 7% rate. It sells at 19x earnings, which is actually cheaper than the average stock in the market.

That's right. Even after today's colossal move, this stock is still less expensive than a ton of truly crummy companies with nowhere near the pristine balance sheet that Microsoft possesses, with its $100 billion in cash currently. Microsoft pays a 36-cent quarterly dividend that gives you a 2.5% yield, which again is better than the 2.1% average yield you get from the S&P 500.

Now, why is this stock so inexpensive versus the rest of the market? Simple: its history.

Microsoft had been perceived to be an also-ran, a boring company with a product that increasingly seemed outdated, with little exposure to the era's big trends -- social, mobile, cloud and artificial intelligence. Its previous CEO, Steve Ballmer, had made a series of bad bets, the last of which was a desperate gambit to get into cellphones with his $7.2 billion purchase of Nokia's phone business three years ago. It was one of the most boneheaded buys in history, particularly because it precipitated at $7.8 billion write-off just two short years later.

But as I always say, what matters is the future, not the past, and I think this company's growth rate is accelerating rather rapidly because of its gigantic cloud bet. If that's the case, then we are going to look back and laugh that we were able to get Microsoft's stock this inexpensively.

Now the quarter before this one was widely perceived as a disappointment. However, this one was so strong that I have to believe the company is making real progress, to the point where I believe it is only selling at about 16x 2018 earnings, which is how you have to value these growth stocks. You can't just look at the short term.

To sum it up, Microsoft -- with that growth rate, with that dividend, with those prospects -- is an outstanding stock for anyone who wants to have a fairly decent reward without a lot of risk. In an era where there are precious few ways to get decent income, Microsoft, after this incredible quarter, represents a very strong opportunity.

OK, how about Facebook?

This social media company, which is part of our Action Alerts PLUS charitable trust portfolio, hit its all-time high this week, $122, giving it a $349 billion market valuation. The stock is on fire in part because we just learned that Facebook Messenger now has one billion users after gaining a staggering 200 million users since the year began. That's a pretty monumental refutation of those who think the world is going toward Facebook competitor Snapchat.

But how about the valuation? Facebook sells at 31x earnings, 50% more than the average stock. So it sure looks expensive. But it grows at 31%, which makes it astoundingly cheap, as we have seen growth stocks trade as high as two times its growth rate.

More important, I think, is that Facebook's growth rate actually is accelerating. Right now it looks like the stock is trading at 20x 2018 earnings, which is equal to the average stock in the S&P 500 now. I have to tell you, though, that when I put pen to paper I think I see a company that could earn a lot more than current Wall Street estimates, enough that I think it is only selling at 17x earnings.

Now, Facebook, unlike Microsoft, has no dividend. And it's also in a fast-moving space where some company conceivably could come out of nowhere with a better mouse trap. I mean, who had heard of Pokémon Go a week ago? Or who would believe that Apple (AAPL) - Get Report , the quintessential growth company and another Action Alerts PLUS holding, now has no growth?

That said, I pronounce Facebook as relatively inexpensive vs. a ton of other growth stocks in the market, suitable for those individuals willing to take some risk in order to get a lot more reward than Microsoft's stock can offer.

Finally, let's take Amazon. Here's a company that doesn't really trade on earnings or you would clearly never touch the stock, because if you actually tried to compute it -- and it's not easy -- you might say that it trades at 117x earnings.

Why is it so difficult to nail down? Because Amazon doesn't play by the rules. There are points in time where it doesn't really care about what it earns; rather, it's interested in rapid growth. If this company sees an opportunity to grow more quickly -- say, in India -- it might forego producing earnings entirely. If it senses that Walmart (WMT) - Get Report is coming after it aggressively, which happens to be the case, it might be willing to take some sort of hit to its bottom line to stop the Bentonville giant.

Amazon will do what it wants to stay fast-growing. You don't want this company, for example, to pay a dividend because that would mean its CEO, Jeff Bezos, can't come up with something better to do with the money. Like many pure growth stories we just want to see the sales line, like the 27% growth it showed last quarter. That's totally amazing given its $350 billion size and its anticipated $134 billion in sales.

Now I can easily justify paying $56 for Microsoft even after it's up 6% on those good earnings. It's tougher to shell out $122 per Facebook share unless I think about the earnings in the out years. Amazon? You have to believe that it will do the same thing to every other retail category that it has done for books and electronics and apparel. You have to believe it will destroy the mall.

Here's the thing, though. It might very well do so. The rest of retail is sure trading as if it will.

For me, that means that if you are a young investor and can take a lot of risk -- as this stock is risky by nature given its hard-to-nail down valuation -- then you should do so. It has proven clever enough to reinvent shopping. Witness the Amazon button it's offering in your house that you can push and instantly you can order dozens of household items. Witness the same-day service that can make it more convenient than walking across the street to the store.

There's simply nothing in this company's DNA to think it can't disrupt the rest of retail.

So, here's how I look at it. You need to assess your risk and your reward. The stock of Microsoft, arguably, is for anyone who needs income and isn't looking for a home run. Facebook may turn out to be a lot cheaper than it looks, ideal for a growth seeker. Amazon? This stock is a leap of faith. If you believe, by all means, do some buying. But recognize that a lot more things have to go right for this one to keep going higher, even as history suggests that's exactly what is going to happen.

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