It's late August 2004, and you have a dilemma. You have $5,000 to invest, and you can't decide between two stocks: a growth stock and a value play. The growth stock is Google, a muchdiscussed leader in search engines. You can buy in at $100 per share. No one seems to have a clue regarding the value of this company, and you don't really know anything about search engines, except that you can look up old highschool buddies on Friday afternoons at work.
The value pick is Microsoft
Today, Microsoft trades around $31 per share, which amounts to a capital gain of 15% over the course of the past 3plus years, alongside another $4.15 per share in dividends. That's certainly not very exciting. However, Google now trades at $650, having yielded a 550% return over the same period. The $5,000 you invested in Microsoft would have returned $6,500; the $5,000 you might have invested in Google would be worth $32,500. Should you consider the difference between the two investments ($32,500  $6,500 = $26,000) as the opportunity cost of choosing the safer investment?
Perhaps not. But this admittedly simplistic illustration suggests that you might pay a price for ignoring highgrowth sectors such as biotechnology, the Internet, and nanotechnology. Highgrowth investors would respect the tenets of fundamental analysis, but also recognize that sometimes you need to look beyond traditional valuation techniques to find the next ultimate growth stock.
The method to our madness
Let's imagine that fictitious biotech startup "CureAll" trades at $5 per share and has 10 million shares outstanding. The company will be spending $10 million each year to develop a latestage drug for the next four years. The new drug comes on the market in the fifth year and will return $100 million each year thereafter. We might use a discount rate of 15% for this company. (Think of the discount rate as the rate of return you would require on your investment, given a particular level of risk.)
To value any company, we must first add up the present value of all future cash flows. You can determine the terminal value (year five and beyond) by dividing the $100 million cash flow by the discount rate. We would then need to determine the present value of that figure. The numbers would look like this:
Year 1 
Year 2 
Year 3 
Year 4 
Year 5 Onward 


Cash flows 
($10 million) 
($10 million) 
($10 million) 
($10 million) 
$100 million/.15 = $667 million 
After that, it's just a matter of taking the present value of each of the cash flows:
(10/1.15) + (10/1.15^{2}) + (10/1.15^{3}) + (10/1.15^{4}) + (667/1.15^{5}) = $303.3 million
We would then divide the $303.3 million by 10 million shares, which would yield an intrinsic value of $30.33 per share for this company.
In other words, you can buy a stock worth $30.33 for a mere $5 a share. Even a value investor would see this as a good deal, right? Not so fast  there's one more thing to consider. Let's say that there's a significant possibility that the drug will not be approved. In our simple example, such a scenario would lead to a valuation of zero for the company. Still interested? At this point, many investors would walk away.
But growth investors  at the Fool, we call them Rule Breakers  would dig deeper. Next, they'd subject CureAll to a probability analysis. If the odds of the drug being approved are 50%, then your expected return is very attractive. If the drug is approved, your $5 share is worth $30.33, resulting in a profit of $25.33. If the drug is rejected, your $5 share is worth nothing, resulting in a loss of $5. Overall, your expected return is $10.17, or [0.5 ($25.33) + 0.5 (5)].
To accurately determine the probabilities, we would need to consider how similar drugs have fared in the past, and examine the track record of the firm's management. At some point, our analysts would decide whether to invest in CureAll. Traditional valuation methods would affect the decision, but other qualitative factors would also come into play. This hypothetical example illustrates a few lessons for everybody. First, it might be wise to invest in companies with a positive expected return  even if there's a possibility of losing everything. With diversification, you'll benefit over the long term. Second, growth investing demands patience and fortitude. It can take several years for your investment to pay off. Sometimes, the investment might not pay off at all. Finally, the illustration shows that there's an art and a science to growth investing.
The vision thing
One of the most difficult tasks in valuing any company is trying to predict future cash flows. Obviously, this task is easier with established companies such as Microsoft, General Electric
When David Gardner, lead analyst for Rule Breakers, first invested in Amazon.com back in 1997, he had to look beyond classical valuation techniques and envision the opportunities for a firm in this industry. That longterm vision has rewarded David handsomely  Amazon.com stock is up more than 1,500% since he bought it.
The events a few years back involving Archipelago, a fully electronic stock exchange, offer yet another instructive case study. I think even David would admit that when he recommended this stock, he never envisioned that it would rocket up almost 60% in one day, as it did back in 2005. Still, he was able to look beyond the fundamentals and make an informed prediction as to where the trading industry was headed. With Rule Breaking investing, you need to be able to assess what could be, far more than what is. Now, as many of you might know, Archipelago has been absorbed into NYSE Euronext
There are, however, considerable risks with this strategy. One of our biotech stock selections fell almost 60% before we withdrew our recommendation. You may not know the name, but remember how hot Dendreon
Nothing to fear but fear itself
To improve your odds of finding the next ultimate growth stock, use traditional analytical techniques as well as more qualitative approaches. In the end, respect the numbers but refuse to be enslaved by them.
That's our tack at Rule Breakers. Thus far, our picks are crushing the market since our launch in October 2004. Vertex Pharmaceuticals, a biotech with some very promising drugs in its pipeline, has returned nearly 200% since we first recommended it in February 2005. Vertex has drug partnerships with powerhouses like GlaxoSmithKline
If you'd like to join our growing community of investors in this ongoing search for the next ultimate growth stock, why not take a 30day free trial? A free trial gives you full access to all our recommendations. If you don't like what you see, just cancel your trial, no questions asked.
This article was originally published on May 13, 2005. It has been updated.
John Reeves. NYSE Euronext is a Rule Breakers recommendation. Amazon.com is a Stock Advisor pick. Microsoft is an Inside Value selection. GlaxoSmithKline is an Income Investor recommendation. The Motley Fool has a disclosure policy.