Net a +230% Gain by Ignoring This Common Ratio

You probably know the name Bill Miller. Aside from Warren Buffett, he might be the closest thing the investment world has to a rock star.

Every year, millions of investors set out with one goal in mind: to outperform the S&P 500. Miller’s Legg Mason Value Trust did that for an impressive 15 years in a row.

That streak was finally broken in 2006, but his reputation was firmly cemented at that point. From inception in April 1982, Miller had steered his fund to annualized gains of +16%. That was good enough to turn a $10,000 investment into $395,000 — about $156,000 more than a broad index fund would have returned.

After a long overdue slump, Miller’s fund is back on top of the charts again. In fact, the fund’s +47% gain during 2009 was 1,200 basis points ahead of the S&P 500.

Here’s what you might not know. Miller achieved stardom and ran circles around the competition by taking large stakes in companies like eBay (Nasdaq: EBAY), Google (Nasdaq: GOOG), and (Nasdaq: AMZN) — highfliers that value purists wouldn’t touch.

The message is clear: if P/E ratios are your only value barometer, then get ready to let some profits slip through your fingers. In fact, Investor’s Business Daily has found that some of the market’s biggest winners were trading above 30 times earnings before they made their move.

Investors like Bill Miller see value through a different prism. He evaluates qualitative (i.e. economic moats) and quantitative factors to calculate a firm’s intrinsic value. The backbone of that calculation projects future cash flows and then discounts those earnings back to today’s dollars.

All too often, novice investors buy into preconceived notions of what’s cheap and what’s expensive. A stock with a P/E below 10 may be a better deal than another trading at a P/E above 20. But then again it might not. These figures might get you in the ballpark — but biting hook, line and sinker can cost you big.

Putting aside the fact that earnings can be inflated by asset sales, deflated by one-time charges, and distorted in other ways, let’s remember that today is just a brief snapshot in time.

Look at Alcoa (NYSE: AA), which posted first quarter adjusted earnings of $0.01 per share. Annualizing that profit and applying an average market multiple of 18 would suggest that the world’s largest aluminum producer is worth a grand total of $0.72 per share.

Now, this is an exaggerated example and there are certainly extenuating circumstances at play. But the point remains the same: when you become a part owner in a company, you have a claim not just on today’s earnings, but all future profits as well.

The faster the company is growing, the more that future cash flow stream is worth to shareholders.

That’s why Warren Buffett likes to say that “growth and value are joined at the hip.”

You can’t encapsulate the inherent value of a business in a P/E ratio. Take Amazon, for example, which has traded at 66 times earnings on average during the past five years. On occasion, the stock has garnered multiples above 80. Many looked at that figure and immediately dismissed the company as exorbitantly overpriced. And for most companies that would be true.

But as it turns out, the shares were actually cheap relative to what the e-commerce giant would soon become. In fact, the “expensive” $35 price tag from March 2005 is only about 12 times what the company earns per share now — and guys like Bill Miller that spotted the firm’s potential have since enjoyed +230% gains.

Digging into the annual report archives, I see where CEO Jeff Bezos applauded Amazon’s sales of $148 million in 1997. Today, the firm rakes in that amount every 2.2 days. Clearly, that type of hyper-growth deserves a premium price.

And that’s exactly why price-conscious value investors shouldn’t automatically fear growth stocks — growth is simply a component of value.

Let me show you an example. The table below depicts the impact of future cash flow growth assumptions on Company XYZ which trades at $10. For the sake of consistency, we will keep all other variables constant.

If free cash flows climb at a modest +6% annual pace during the next five years, then Company XYZ would be worth about $13.30 per share or a +33.0% return. From there, its projected value quickly ramps up to returns of +46.9%, +101.1% or even +148.8%.

We’ve been taught to believe there’s an invisible velvet rope separating value stocks from growth stocks. But as you can see with Company XYZ, it’s actually growth that determines value. So don’t be blinded to the possibility that the market’s most promising growth stocks can sometimes be the cheapest.

Editors Note: Just days ago Nathan helped his Market Advisor readers close out a position in Claymore/Delta Global Shipping (NYSE: SEA) for a +30% gain. He also gave his readers a quick update on one of his Top Ten Stocks for 2010 — a market leader that gained +151% last year and is poised to crush the S&P 500 yet again this year. The stock is already up +19% since Nathan recommended it a couple months ago… and he thinks it has another +40% to go from here. To learn more, scroll down to “Stock #5” in this report.