This show originally aired on January 19, 2012Search Jim Cramer's "Mad Money" trading recommendations using our exclusive "Mad Money" Stock Screener and watch Jim Cramer's "Mad Money" Post Game video exclusively on TheStreet.com.
NEW YORK ( TheStreet) -- "I want to show you a new way to use earnings season," Jim Cramer told his "Mad Money" TV show viewers, as he dedicated his entire show to helping individual investors navigate the overwhelming nature of the busiest time on "Wall Street." Cramer explained that it's important to put earnings and their accompanying conference calls into context, as earnings alone can't be relied on to predict a stock's future behavior as it once was. In today's complex markets, Cramer said that earnings are only one piece of the puzzle that determines where a stock is headed after it reports. According to Cramer, earnings seasons are a great time for investors to re-evaluate their portfolios and decided which stocks they should trim and which they need to buy more of. He said that earnings should allow investors to "hone their thinking" on which stocks are performing and which ones aren't. Cramer said that when he looks at a company's earnings, he first looks at the predictive value of those earnings. Did the company beat even the highest analyst estimates? If so, those analysts are likely to be raising their estimates soon. Did the company produce a genuine beat with higher revenues? If so, then the company is on track. But if the earnings came from trick accounting, like buying back stock, favorable tax rates or aggressive cost-cutting, then those earnings may not last. Cramer told investors not to rely on just a company's price earnings, or p/e, ratio as a measure of whether a stock is cheap or expensive. He said investors must always factor in growth by using the PEG ratio, which is a company's multiple divided by its growth rate. Cramer said he's willing to pay up to twice the PEG ratio for a company that's growing. Those with PEG ratios below one are super-cheap, assuming there aren't any underlying issues.
Sector Holds KeyCramer said his next step toward evaluating a company's earnings is to look at its sector. He explained that in the old days, a company's sector could account for 50% of its performance. But in today's markets that are riddled with ETFs that lump similar stocks together, a company's sector is more important than ever.
Look at the banks, for example, said Cramer. Since the financial crisis began, it didn't matter whether a bank was doing well or not. If it was a bank, its stock was headed lower regardless. Cramer said the key is figuring out which stocks in a sector, if any, can buck that trend.When the retail sector began to come back into favor in 2009, Cramer recounted how he immediately gravitated toward the discounters and the dollar stores in particular. Why? Because he knew that stocks like Dollar Tree ( DLTR) and Dollar General ( DG) already had earnings momentum, so when money began returning to the retail group, the dollar stores would shine. Sector is even more important when it comes to technology stocks, said Cramer. This is in part because technology makes up a whopping 15% of the S&P 500, but also because technology encompasses a host of sub-sectors, everything from semiconductors to disk drive makers, software companies to cloud computing and infrastructure players. Cramer said that each of these sub-sectors is unique, with its own set of growth rates and expectations. When investing in tech stocks, Cramer said investors must pay very close attention to a company's sub-sector and how it relates to its peers. "There is no room for error," he explained, for when a company in this group misses earnings, its shares get pancaked immediately.
Gross Margins MatterAnother key to figuring out a company's earnings trajectory: Its gross margins, Cramer told viewers. That's the difference between what it costs to make an item versus what they can sell it for. Cramer said there are a lot of factors that go into a company's gross margins. In the case of a restaurant like Chipotle Mexican Grill ( CMG), Cramer said the key metrics are its food costs, the price it pays for beef, chicken and guacamole, and its labor costs. For other industries, like semiconductors, gross margins are often influenced by inventory levels. When demand is high, a company can produce as many chips as possible and sell every one at full price. But when demand slows and inventory builds, these same companies must discount their chips to keep them moving, thus lowering gross margins.
For still other companies, like the oil and gas sector, determining gross margins may be almost impossible. For these giants, there are multiple costs for drilling and getting the oil out of the ground, versus transporting and storing it, versus refining it into finished products. Cramer said that's why so many big oil firms are breaking themselves up into separate companies with single functions. It's simply easier for Wall Street to determine what they do and how much money they'll be able to make.When it comes to gross margins, Cramer concluded, Wall Street wants consistency. Changes in gross margins often lead to changes in stock price.