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

Tickers in this article: CMG COH DG DLTR YUM
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This program last aired Nov. 2, 2012.

NEW YORK ( TheStreet) -- "I want to show you a new way to use earnings season," Jim Cramer told "Mad Money" viewers, dedicating his entire show Monday 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. When 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, 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.