Buy Cheap Growth

As an investor, you probably know that stocks are priced based on the market's expectations for the future. But if you look at things in more depth, you'll realize that those expectations 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.

But that third item -- strategic direction -- is a tough nut to crack. A company's strategic direction lets it 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. The remainder is the market's current estimate of the growth strategy's 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 gain 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, 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 companies (assuming a 12% required rate of return and 4.8% annual "natural" growth):

On one end sits Internet content provider pioneer Akamai Technologies. While the company may very well have a bright future ahead of it, its growth strategy makes up more than 75% of its stock price. Because of that, it has to grow like wildfire just to justify its current price. On the other end, clothing retailer Limited Brands trades extremely cheaply. As it stands, the market seems to expect it to more or less tread water, and actually lose significant ground to the overall economy over time. 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 "Limited Brands" to both those questions, congratulations! You've got the makings of a value investor. Any growth Limited Brands may see is available far more cheaply than the growth available from Akamai. 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 manage to grow.

Get started now
At Motley Fool Inside Value, we know superior investing returns can be earned by buying growth when it's cheap. That's why Limited Brands is one of the selections in our market-beating service. In the future, its 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.

This article was originally published 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. Limited Brands is an Inside Value pick. Limited Brands, Eli Lilly, and United Parcel Service are all Motley Fool Income Investor choices. Akamai is a Rule Breakers choice. The Fool has a disclosure policy.