The Next Ultimate Growth Stock

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 much-discussed 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 high-school buddies on Friday afternoons at work.

The value pick is Microsoft (NASDAQ:MSFT), the ubiquitous software giant. Several analysts have crunched the numbers on this one and determined that the share price is significantly undervalued at $27. And doesn't Peter Lynch recommend that you buy what you know? You may not know search engines, but you know that everyone uses Microsoft's products. In the end, you convince yourself to buy $5,000 of Microsoft at $27 per share. Google is just too darn risky.

Today, Microsoft trades around $31 per share, which amounts to a capital gain of 15% over the course of the past 3-plus 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 high-growth sectors such as biotechnology, the Internet, and nanotechnology. High-growth 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 start-up "Cure-All" trades at $5 per share and has 10 million shares outstanding. The company will be spending $10 million each year to develop 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 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:

After that, 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'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 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, 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 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'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 (NYSE:GE), and Citigroup (NYSE:C), which have steady cash flows and relatively even growth rates, and clearly not as easy with a company like LDK Solar (NYSE:LDK), whose real potential is yet unknown.

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 long-term 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 (NYSE:NYX). And many of our customers saw their original stake in this company increase by more than 300%.

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 (NASDAQ:DNDN) was several months ago only to fall back into relative obscurity again in a matter of weeks? These types of collapses happen when you swing for the fences. Sadly, home run hitters strike out too. 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 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 (NYSE:GSK), and the Rule Breakers team believes it has the potential to become a biotech giant.

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? 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.