Yahoo Finance Jim Cramer: Weigh Risk and Reward When Choosing Stocks — Here’s How To Do It
Jim Cramer is one of the most famous financial personalities in the world, perhaps most well-known as the host on CNBC’s “Mad Money.” On a daily basis, the former hedge fund manager covers a wide range of market-related topics, all designed to educate investors about how to succeed.
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In a recent segment of “Mad Money,” Cramer spoke about the importance of weighing risk and reward when choosing stocks. Here’s a look at what exactly Cramer meant by that, and how you can apply his tips to your own portfolio.
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Understanding the Upside and Downside
Theoretically, any stock can either rise by an infinite amount or fall to zero. In reality, though, most stocks have a valuation range that they tend to stay in, barring some unforeseen catastrophe. This is because stocks are engaged in a daily battle of supply and demand between buyers and sellers.
When prices are too high, sellers tend to enter the market, and when prices are too low, buyers take over. The key to successful investing, according to Cramer, is to determine how much growth investors will pay for a stock on the way up and when value investors will jump in when the price is on the way down.
Once you’ve figured out what that approximate range is, you can determine whether or not you should be buying a stock.
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How To Determine Whether a Stock Is Expensive or Cheap
Cramer suggests that investors use the time-honored Wall Street methods of GARP and PEG when valuing stocks. GARP is an acronym for “growth at a reasonable price,” while PEG stands for “price-to-earnings growth rate.”
Growth at a reasonable price refers to looking for companies that have growing earnings but aren’t overvalued by conventional measures. Price-to-earnings growth rate is used in this calculation. By traditional standards, a stock is reasonably valued if its growth rate is at or below its price-to-earnings ratio.
For example, if you have a company growing at 15% per year, it can be a value if its P/E ratio is 15 or less. However, true GARP investors search for PEGs closer to 0.5 than 1.0.
Unlike pure growth investors, who are willing to pay nearly unlimited P/E ratios for stocks growing at 50%, 100% or more per year, GARP investors have a value tint. While still looking for growth, they prefer more modest growers trading for low prices.
For example, while a growth investor might like a company growing at 40% per year trading at a 30x P/E, a GARP investor would likely prefer a company growing at 20% per year and trading at 12x earnings. While both stocks have PEG ratios of less than 1, a GARP investor would generally look for a more reasonable valuation.
Caveats
Cramer himself points out that while GARP and PEG and other valuation measures can help you determine a fair price for a stock, there’s no such thing as certainty on Wall Street. When evaluating stocks using these methods, you have to first be sure that you’re looking at companies with actual earnings. Unprofitable companies often trade on the price-to-sales ratio, which doesn’t allow for a fair valuation assessment using GARP and PEG principles.
Also, just because analysts — and even companies themselves — may project certain earnings growth rates doesn’t mean that a business will achieve them. If there are earnings surprises, either upwards or downwards, you should still expect a reaction in a stock.
How Can You Use This Data in Your Own Portfolio?
Once you’ve done all your homework, you can put together the perfect stock-buying scenario.
As Cramer outlines it, find growing companies with a PEG below 1.0, and preferably closer to 0.5. This is the point at which value buyers typically get interested in a stock, meaning it could be a good time to make your own purchase.
On the upside, growth investors often push a hot stock well beyond a 1.0 PEG, but the hotter it gets, the more out of balance your risk/reward ratio will get. This is what Cramer means by weighing risk and reward when it comes to choosing stocks.
Bottom Line
While there’s no way to predict the short-term movements of a stock, buying growing companies at a fair price is a proven strategy for finding long-term winners, and GARP and PEG can help. As Cramer points out, though, you’ll want to make sure you’re buying quality, growing companies — not just ones that have a very low PEG ratio or are not yet profitable.
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This article originally appeared on GOBankingRates.com: Jim Cramer: Weigh Risk and Reward When Choosing Stocks — Here’s How To Do It
