Cramer's 'Mad Money' Recap: Making Sense of Earnings Season

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This program last aired Aug. 3.

NEW YORK ( TheStreet) -- "I want to show you a new way to use earnings season," Jim Cramer told "Mad Money"viewers Friday. 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 -- 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, earnings are only one piece of the puzzle that determines where a stock is headed after it reports.

Earnings season is a great time for investors to re-evaluate their portfolios and decide which stocks they should trim and which they need to buy more of. 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 revenue? 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 1 are super-cheap, assuming there are no underlying issues.

The Sector Is Key

Cramer said his next step towards evaluating a company's earnings is to look at its sector.

In the old days, a company's sector could account for 50% of its performance. But in today's markets riddled with exchange-traded funds 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 said he immediately gravitated towards 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. 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 Matter

Another key to figuring out a company's earnings trajectory is its gross margins, or the difference between what it costs to make an item versus what it 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), 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, transporting and storing it, and refining it into finished products.

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, he said.

When it comes to gross margins, Cramer concluded, Wall Street wants consistency. Changes in gross margins often lead to changes in stock price.

Listen to Management

Cramer's next thing to look for on conference calls and earnings reports is a signal about the future, dividend boosts or catalysts to boost sales.

Far too often companies are enamored by stock buyback programs as a way to return value to shareholders, but far too often buybacks do nothing to raise share prices and only work to help management beat estimates. That's why Cramer said he vastly prefers dividends as a way to reward a company's shareholders.

With interest rates at historic lows for the foreseeable future, Cramer said dividends have taken on increased importance. That's why nearly 40% of the total return of the S&P 500 over the past 10 years has been dividends, and why Cramer has preached almost nightly on how reinvesting dividends can significantly boost a portfolio.

Cramer said he's always listening for management to talk about their dividends and the possibility of raising them in the future. In addition, he's also listening for what he calls catalysts, something that could boost a company's share price in the short term.

Catalysts come in all forms. For pharmaceutical companies, catalysts may be a drug that's entering Stage III testing or expanded uses for existing drugs they're already producing.

In the tech sectors, catalysts are often new products or technologies that should seriously boost business, he said. For pipeline companies, catalysts can be expansions of their network into new, lucrative areas, he added.

But no matter in what form they appear, Cramer said talk about future catalysts or dividend boosts will always give investors reasons to buy when the market dips.

Geopolitical Risks

Cramer's final factors to consider are geopolitical risk and a stock's chart.

Geopolitical risk isn't just about unrest in the Middle East. There are now dozens of factors that can affect a company's earnings. In 2011, for example, the financial crisis in Europe held bank stocks across the globe hostage for months on end, he explained.

A slowdown in the Chinese economy affects the earnings of countless companies, from industrial equipment makers to mining and materials to even retailers such as Coach ( COH) and Yum Brands ( YUM).

As for a stock's chart, Cramer said far too often a stock will fall after an earnings release simply because the chartists feel the stock has hit a resistance level, or some other technical indicator has come up short.

But for companies with great earnings momentum, selloffs like these can be the perfect buying opportunity -- but only if investors have done their homework to know the selloff was unwarranted, he said.

To watch replays of Cramer's video segments, visit the Mad Money page on CNBC.

-- Written by Scott Rutt in Washington, D.C.

To email Scott about this article, click here: Scott Rutt

Follow Scott on Twitter @ScottRutt or get updates on Facebook, ScottRuttDC

At the time of publication, Cramer's Action Alerts PLUS had a position in DG.

Jim Cramer, host of the CNBC television program "Mad Money," is a Markets Commentator for TheStreet.com, Inc., and CNBC, and a director and co-founder of TheStreet.com. All opinions expressed by Mr. Cramer on "Mad Money" are his own and do not reflect the opinions of TheStreet.com or its affiliates, or CNBC, NBC Universal or their parent company or affiliates. Mr. Cramer's opinions are based upon information he considers to be reliable, but neither TheStreet.com, nor CNBC, nor either of their affiliates and/or subsidiaries warrant its completeness or accuracy, and it should not be relied upon as such. Mr. Cramer's statements are based on his opinions at the time statements are made, and are subject to change without notice. No part of Mr. Cramer's compensation from CNBC or TheStreet.com is related to the specific opinions expressed by him on "Mad Money."

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