It's late August 2004, and you have a dilemma. You have $5,000 to invest, and you can't decide between two stocks: One is a growth stock, and the other is a value play.
The growth stock is Google
The value pick is Hasbro
Today, Hasbro trades at roughly $30 per share, which amounts to a gain of 67% over the course of the past 43 months. Not bad, but not very exciting. However, Google now trades at $460, which has yielded a 360% return over the same period. The $5,000 you invested in Hasbro is now worth $8,330; the $5,000 you might have invested in Google would be worth $23,000. Should you consider the difference between the two investments ($23,000 - $8,330 = $14,670) as the opportunity cost of choosing the safer investment?
Perhaps not. But this simplified illustration suggests there might be a price to be paid for ignoring high-growth sectors such as biotechnology, the Internet, and nanotechnology. At Motley Fool Rule Breakers, we respect the tenets of fundamental analysis, but we also know that sometimes you have to look beyond traditional valuation techniques to find the next ultimate growth stock.
The method to our madness
Let's imagine fictitious biotech start-up "Cure-All" is trading at $5 a share and has 10 million shares outstanding. The company will be spending $10 million a year developing a late-stage drug for the next four years. The new drug comes on the market in the fifth year and will return $100 million a year thereafter.
For this company, we might use a discount rate of 15%. (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 the present value of all future cash flows. The terminal value (year five and beyond) is determined 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+ |
|
|---|---|---|---|---|---|
|
Cash Flows |
($10 million) |
($10 million) |
($10 million) |
($10 million) |
$100 million/0.15 = $667 million |
Then it's just a matter of taking the present value of each of the cash flows:
(-10/1.15) + (-10/1.152) + (-10/1.153) + (-10/1.154) + (667/1.155) = $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 is a significant possibility that the drug would 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 would subject Cure-All 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 [.5 ($25.33) + .5 (-5)].
To determine the probabilities accurately, we would need to consider how similar drugs have fared in the past and examine the track record of the company's management. At some point, our analysts would decide whether to invest in Cure-All. 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 is a possibility of losing everything. With diversification, you will 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 is an art and a science to growth investing.
The vision thing
One of the most difficult tasks in valuing a company is trying to predict future cash flows. Obviously, this task is easier with established companies such as Procter & Gamble
When David Gardner, lead analyst for Rule Breakers, first invested in Amazon.com
There are, however, considerable risks with this strategy. One of our biotech stock selections was down almost 60% before we withdrew our recommendation. When you swing for the fences, there will be strikeouts along the way. We recommend that investors allocate anywhere from 5% to 30% of their portfolios to growth stocks, depending on their time horizon and risk tolerance.
Nothing to fear but fear itself
To find the next ultimate growth stocks, you must 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 the tack we take at Rule Breakers. Thus far, our picks are beating the market by 11 percentage points since our launch in October 2004.
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 30-day free trial? You'll have full access to the current issue and the entire catalog of our back issues, which includes write-ups on more than 50 past recommendations.
This article was originally published on May 13, 2005. It has been updated.
John Reeves does not own shares in any of the companies mentioned above. Hasbro and Amazon are Stock Advisor recommendations. Colgate-Palmolive is an Inside Value recommendation. The Motley Fool has a disclosure policy.
