Why are investors willing to pay only 10 times earnings for some stocks, but 20, 50, even 100 times earnings for others?

The short answer: growth. Companies that can grow their earnings meaningfully can make lofty current P/E ratios look cheap in hindsight.

Of course, any company can promise a rosy, growth-rich future. Figuring out which companies can actually deliver is far trickier. In this series, I take the first step by identifying companies that have put up the best growth track records in their respective sectors.

Below, I've listed the top sales growers in Biotechnology over the last five years. Here's how to interpret each data column.

  • Five-year sales growth: I rank each company's sales growth, to capture its pure trailing expansion without regard to the vagaries of earnings.
  • Five-year EPS growth: Since sales growth means nothing if it doesn't ultimately fall to the bottom line, I've also included each company's five-year trailing EPS growth rate.
  • Five-year analyst estimates: This column shows us how much EPS growth analysts expect over the next five years. Just keep in mind that analysts tend to grossly overestimate a company's prospects.
  • Five-year ROIC range: Return on invested capital basically shows you how efficiently a company is converting its debt and equity into profits. We want companies that can do a lot with a little. By looking at the five-year range, we can start to gauge both the power and the consistency of a company's profit engine.

Company

5-Year Sales Growth

5-Year EPS Growth

5-Year Analyst Estimates

5-Year ROIC Range

Onyx Pharmaceuticals (Nasdaq: ONXX) 307.3% NM 38.6% -15.5% / 4.1%
Dendreon (Nasdaq: DNDN) 274.3% NM -31.0% -40.1% / -33%
Spectrum Pharmaceuticals (NasdaqGS: SPPI) 271.7% NM N/A -44.4% / 28.1%
Alexion Pharmaceuticals 244.8% NM 31.6% -33.6% / 14.1%
Theratechnologies 186.5% NM N/A -41.3% / 7.7%
Halozyme Therapeutics 147.9% NM N/A -163.7% / -35.8%
Targacept 111.2% NM -235.1% -30% / -0.4%
Pharmacyclics 99.4% NM N/A -75.4% / -27.4%
Ariad Pharmaceuticals (NasdaqGS: ARIA) 94.3% NM N/A -161.8%/-90.7%
Momenta Pharmaceuticals (NasdaqGS: MNTA) 82.9% NM N/A -40.1% / 52.6%

Source: Capital IQ, a division of Standard & Poor's. NM = not meaningful; EPS growth that is NM results from losses during the period. N/A = not applicable; analyst estimates that are N/A result from lack of analyst coverage.

Use the table above as a first step to help you generate ideas for your own further research. Once you identify stocks worth a closer look, the following three steps will help you further assess their growth prospects:

  • Carefully study the table for possible danger signs, such as high sales growth but low EPS growth, analyst growth expectations significantly trailing past growth, and low ROIC figures. Then follow the trail.
  • Find out how the company achieved its prior growth: organically, or via acquisition? Can it sustain that previous growth?
  • Pay attention to how management plans to implement its growth plans. Does its strategy seem prudent and plausible to you?

Remember: The more profitable, efficient, and predictable growth a company can achieve, the more we investors should be willing to pay.

When we look at this list of top growers, we notice something. Despite tremendous top-line growth, none are currently profitable. But unlike in other sectors like consumer goods or retail, this isn't necessarily a red flag. Often, the biggest sales growers are coming off of very low bases because of the nature of the biotech and pharma space. The growth we're seeing from Onyx on down wouldn't be likely otherwise.

For example, Dendreon gained full approval for its Provenge treatment for prostate cancer in 2010. Before that, the revenue line was negligible. That explains its high sales growth rate and its lack of profitability as it ramps up. Looking beyond the initial numbers is key. For an analysis of Dendreon, see Sean Williams' recent article that makes a buy, sell, or hold call. 

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Anand Chokkavelu owns shares of Onyx Pharmaceuticals. The Motley Fool owns shares of Dendreon and Momenta Pharmaceuticals. Motley Fool newsletter services have recommended buying shares of Momenta Pharmaceuticals. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.