How Much Should You Pay for a Growth Stock?

Investing in great growth stocks is entirely consistent with buying only at a margin of safety. Growth, after all, is a component of value. We think the best growth stocks often present the widest margins of safety, especially if you catch them early. Rather than "paying up for growth," astute investors may actually be getting the best of both worlds--buying into fast-growing firms at discounts rarely glimpsed elsewhere in the market. Yet we're often greeted with intense skepticism--at best!--when we raise ideas like these with other margin-of-safety-oriented investors, especially more traditional value investors. So we've decided to plant a stake in the ground and examine the record.

We'd like to share some interim results from our quantitative growth investing research. We're studying the return earned by investors in a sample of 50 widely known growth stocks over periods starting in 1990, 1995, and 2000, in an attempt to increase our insight into growth stock valuation--and just how much you can pay for growth. Of course, there's no chance that we'll abandon our preference for investing with a margin of safety--this remains a core Morningstar principle. In our view, one of the most frequent investment sins is overpaying for growth. It's entirely unnecessary, as an informed investor is well positioned to determine when growth is attractively priced--and when it isn't. Margins of safety remain vital, but when it comes to the best companies, there's often more to consider than most investors realize.

Below we'll walk you through our methodology and share some preliminary results for the 1995 cohort, plus certain initial conclusions. However, there's much more to do. We plan to share our subsequent results in Morningstar GrowthInvestor, Morningstar's flagship growth research publication, and selectively on Morningstar.com. For a risk-free trial to Morningstar GrowthInvestor, click here.

Methodology and Caveats
We selected 50 of the best growth companies from the last 15 years, while making sure we had representation from across the economy. This immediately introduces selection bias (the list is not random) and survivorship bias (only companies that remain in business and independent made the list), but this is not important. Our interest is in evaluating the best companies, with a goal of estimating how much is too much to pay for their stocks. We also excluded any short-lived enterprises, even if they were acquired for huge profits to the original investors, as our primary interest lies in firms that can deliver sustained growth. We are, after all, long-term investors.

To estimate returns, we compared each firm's starting stock price in 1995 to the maximum price an investor could have paid and still outperformed the S&P 500. We derived the latter price by deflating each stock's July 1, 2005, price by the average return of the S&P 500 Total Return Index over the 10.5-year period. From 1995, this was 11.4%. Let's walk through an example to see this in action.

On July 1, 2005,  AIG  shares sold for $58.61. To determine how much an investor could have paid for AIG on Jan. 1, 1995, and earned at least an 11.4% annual return, we reduced $58.61 by 11.4% for 10.5 years, which yielded $18.87. (The actual calculation is [58.61/(1.114)^10.5] = 18.87). Although AIG's share price on Jan. 1, 1995, was $15.49, this calculation demonstrates that investors could have paid up to $18.87 per share before they would have underperformed the index. (This calculation is 18.87*(1.114)^10.5 = 58.61). So in the table below, we can compare AIG's $15.49 actual price with the $18.87 maximum price, and note that in this case, an investor could have paid about 22% more before exceeding the "market underperformance" price--or as we prefer to say it, AIG traded with a 22% "growth margin of safety." We also illustrate this with P/E ratios--in this case AIG's actual 14.26 P/E was nicely below the 17.38 maximum P/E an investor could have paid. Some of the maximum P/Es we found are surprisingly large.

Note that we ignored dividends--not because we don't think they're important, but merely to avoid a layer of complexity. In most cases, this reduced each stock's maximum price. So, for example, AIG's $18.87 maximum price was probably a dollar or two higher if we include the dividends an investor would have received over the succeeding decade. We'd also like to stress that these results do not mean that every so-called growth stock is attractively priced. These 50 stocks are relatively rare examples. We also assumed that all investments were made on a "buy-and-hold" basis. We're aware that it can be tough to simply hold many growth stocks, which tend to be more volatile, but note that the majority of the benefits accrue to investors who do just that.

Growth Stocks in 1995: Actual Price, Maximum Price, and P/E
	Actual Price ($)	Maximum Price ($)	Growth Margin of Safety (%)	Actual P/E	Maximum P/E
AIG	15.49	18.87	22	14.26	17.38
Amazon	N/A	N/A	N/A	N/A	N/A
Apollo	0.78	25.11	3,111	1.26	40.50
Bank of America	11.28	14.48	28	N/A	N/A
Bed Bath & Beyond	3.75	13.33	255	37.50	133.29
Biomet	6.22	11.04	77	21.54	38.22
Bristol-Myers	13.77	8.11	-41	15.22	8.96
Brown & Brown	3.63	14.54	301	13.94	55.91
Cardinal Health	13.74	18.72	36	6.84	9.32
Cheesecake Factory	3.11	11.13	258	22.50	80.52
Chico's	0.28	11.19	3,927	12.20	491.04
Cisco	1.95	6.11	213	27.23	85.29
Clear Channel	6.34	9.94	57	40.28	63.13
Coca-Cola	25.75	13.59	-47	26.01	13.72
Colgate	15.84	16.11	2	16.59	16.87
Commerce Bancorp	2.98	9.67	225	8.47	27.51
Dell	0.64	12.66	1,877	17.90	353.92
Directv	6.38	4.99	-22	6.48	5.07
Eaton Vance	1.45	7.70	431	8.50	45.11
eBay	N/A	N/A	N/A	N/A	N/A
Fastenal	10.22	19.75	93	41.71	80.63
FedEx	15.06	26.47	76	13.13	23.07
Fidelity Nat. Fin.	4.46	11.63	160	18.13	47.21
First Data	11.84	12.98	10	25.33	27.78
GE	8.50	11.18	32	14.74	19.39
Home Depot	10.22	12.71	24	36.51	45.40
Intel	3.99	8.44	111	12.19	25.76
Johnson & Johnson	13.69	20.91	53	17.55	26.80
McGraw-Hill	8.36	14.22	70	16.31	27.75
Merck	18.04	10.00	-45	15.16	8.40
Microsoft	3.82	7.95	108	28.83	60.03
Motorola	17.30	5.88	-66	19.59	6.66
M&T Bank	13.60	33.98	150	8.32	20.79
Oracle	2.18	4.28	96	38.04	74.68
Pfizer	6.44	8.72	36	18.70	25.35
Progressive	11.67	31.61	171	12.68	34.35
Qualcomm	1.47	10.82	637	78.25	576.83
Starbucks	3.44	16.43	378	62.50	298.77
Stryker	4.59	15.24	232	24.50	81.27
Sysco	6.44	11.67	81	19.96	36.18
Target	5.90	17.56	198	12.28	36.59
Tiffany	4.88	10.58	117	21.91	47.54
Toll Brothers	2.50	16.17	547	9.26	59.90
T. Rowe Price	7.50	20.15	169	15.96	42.87
Walgreen	5.45	14.83	172	18.49	50.28
Wal-Mart	10.63	15.54	46	19.14	28.00
Wells Fargo	11.69	19.72	69	N/A	N/A
Whole Foods	5.13	38.10	643	16.80	124.92
XM Satellite Radio	N/A	N/A	N/A	N/A	N/A
Yahoo	N/A	N/A	N/A	N/A	N/A
Data as of 01-01-1995.

Please note that some of the above data is lost to time, and not all companies were public over our sample time frame. In Part 2 of our growth research, we share some preliminary conclusions and suggestions for spotting growth stocks early.

>> Click here for Part 2