Buy Cheap Growth

As an investor, you probably know that stocks are priced based on the market's expectations for the future. If you look at things a little more deeply, though, you'll realize that those expectations themselves can be broken up into three parts:

• Proven performance.
• Natural growth.
• Strategic direction.

The first two are rather straightforward. You can find a company's proven performance at nearly any financial website. Additionally, just by getting pulled along by inflation and real growth in the overall economy, most companies have some level of natural growth.

It's that third item -- strategic direction -- that's a tough nut to crack. A company's strategic direction is what lets a business grow faster than the economy by increasing either the overall size of its market or its share of the existing pie. It's what most investors think of when they think of growth. While the other two parts can usually be projected fairly easily, the true value of strategic direction can only be seen in hindsight. By that point, unfortunately, it's nearly always too late for investors to profit.

Cheat the system
Even though you can't figure out ahead of time what a company's growth strategy will really be worth, you can get a good handle on what the market thinks. Simply subtract the other two parts from a company's market price. What's left is what the market currently believes that growth strategy is worth.

With that information in hand, you can make better investing decisions. In essence, the less you pay for a company's growth strategy, the better your chances of winding up on top. After all, if the strategy comes cheaply, then even if that strategic growth doesn't materialize, the company you're holding is still worth something. And if the strategy does pay off, then you've likely got yourself a company worth more than you paid for it.

That, in a nutshell, is how we value investors get our edge. We certainly don't ignore growth. After all, no less a value investing luminary than Warren Buffett admits that "value and growth are joined at the hip." Instead, we simply steadfastly refuse to overpay for the growth we expect to see from our companies. By doing that, we ensure that a larger chunk of that growth finds its way to our pockets.

Put it to practice
To make this work for you, you need to know:

• A company's market price and its most recent earnings (adjusted, if necessary).
• Long-run projections of inflation and economic growth.
• What rate of return you expect from your investment.
• How to perform a discounted earnings calculation (see this article for an example).

With that information in hand, you can get a handle on how much of a company's total market value is made up of each of those three parts. This table shows my rough results for a handful of firms (assuming a 12% required rate of return and 4.8% annual "natural" growth):

On one end sits Internet search titan Google. Its growth strategy makes up more than two-thirds of its stock price -- and that's after its recent earnings practically tripled year-ago levels. On the other end, clothing retailer Gap's growth strategy weighs in at closer to 15% of its stock price. With that in mind, ask yourself these two questions:

1. Which one would you rather own if its growth strategy stumbled?
2. Which one looks like the market's expectations would be a lower hurdle to clear?

If you answered "Gap" to both those questions, congratulations! You've got the makings of a value investor. Gap's potential growth is available far more cheaply than Google's. That gives you a better shot at protecting your money if the company continues to struggle and a better shot at reaping the rewards as an investor if it does grow.

Get started now
At Motley Fool Inside Value, we know that the way to earn superior investing returns is to buy growth when it's cheap. That's why Gap is one of the selections in our market-beating service. In the future, Gap's strategic growth will either materialize or it won't. If it does, we stand to benefit. If it doesn't, we've got one heck of a backstop protecting our money. If this is the way you'd like to invest, join us today. If you'd like a sneak peek before committing, that's OK, too. Your 30-day free trial starts here.

This article was originally published on Jan. 25, 2007. It has been updated.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta did not own shares of any company mentioned in this article. Gap is an Inside Value and Stock Advisor recommendation. The Fool has a disclosure policy.