The Next Ultimate Growth Stock

Take a trip with me. Imagine 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, the other is a value play. The growth stock is Google (NASDAQ:GOOG), a leader in search engines that everyone is talking about. You can buy in at $100 a 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 high school buddies on Friday afternoons at work.

The value pick is Mattel (NYSE:MAT), the popular manufacturer of children's toys. Several analysts have crunched the numbers on this one and determined that the share price is significantly undervalued at $16. And doesn't Peter Lynch recommend that you buy what you know? You may not know search engines, but you know toys. Kids like toys, and parents spend loads of money on their kids. In the end, you convince yourself to buy $5,000 of Mattel at $16 per share. Google is just too darn risky.

Today, Mattel trades at $16.62 a share, which amounts to a slight gain of 3.9% over the course of the past 20 months. There's certainly no fun in those results. However, Google now trades at $411.35, which has yielded a 311% return over the same period. The $5,000 you invested in Mattel is now worth $5,195; the $5,000 you might have invested in Google would be worth $20,550. Should you consider the difference between the two investments ($20,550 - $5,195 = $15,355) the opportunity cost of choosing the safer investment?

Perhaps not. But this admittedly simplistic 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:

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 Rule Breakers analysts 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 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 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 any company is trying to predict future cash flows. Obviously, this task is easier with established companies such as General Electric (NYSE:GE) and Johnson & Johnson (NYSE:JNJ), which have steady cash flows and relatively even growth rates. With growth stocks, it's somewhat different. When David Gardner, lead analyst for Rule Breakers, first invested in Amazon.com (NASDAQ:AMZN) back in 1997, he had to look beyond classical valuation techniques and envision the opportunities for a firm in this industry. That long-term vision has rewarded David handsomely -- Amazon.com stock is up more than 1,000% since he bought it.

The recent events 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. But 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 is part of the NYSE Group (NYSE:NYX). And many of our customers saw their original stake in this company increase by more than 250%.

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
As David has said, "The next ultimate growth stock is out there, and we're confident that our Rule Breakers team will find it." To improve our odds, our analysts use traditional analytical techniques as well as more qualitative approaches. In the end, we respect the numbers but refuse to be enslaved by them.

Thus far, our picks are beating the market by 14 percentage points since our launch in October 2004. The Knot (NASDAQ:KNOT), a media company specializing in all things wedding-related, has been on a run recently -- it's up 62% since it was selected approximately three months ago.

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? Today is a great day to take us up on the offer -- we unveiled two new Rule Breakers picks at 4:00 p.m. EST. A free trial gives you full access to today's issue and the entire catalog of our back issues, which includes write-ups on more than 30 past recommendations. If you don't like what you see, just cancel your trial, no questions asked.

John Reeves owns shares of Johnson & Johnson. Mattel is Motley Fool Inside Value pick, while Amazon.com is a Stock Advisor pick. The Motley Fool has adisclosure policy.