Want to know why biotech investors can name Genentech (S. San Francisco, CA, USA; NYSE:DNA) in their sleep as the industry's most valuable player? Easy. According to Samuel Isaly, manager of the Eaton Vance Worldwide Health Sciences Fund, only 40 of 1,000 biotech companies in biotech's history have ever attained profitability. Of those 40, only two—Genentech and Amgen (Thousand Oaks, CA, USA; Nasdaq:AMGN)—have remained independent and reached the sales and market value heights of the top pharmaceutical makers.

Genentech's business performance is absolutely unparalleled in biotech history. Its astounding success has made it a must-have drug development partner, top employer, boon to patients and rich uncle to investors. Yet this history-making company is far from a great stock at today's prices. How can this be?

Mr. Right and team

For years, Genentech's top management has defied the odds against developing drugs and bringing them to market. Think of CEO Art Levinson and his team as custodians of the nest with insufficient food for all the wide-open beaks of potential drug development programs. They not only correctly have chosen which of their own babies would grow up big and rich, but altruistically have made equally rewarding decisions about partners' offspring.

In a world where but one-tenth of drugs that enter human trials are ever approved and marketed, and even 40% of those in phase 3 don't make it, Genentech for two years has scored 100%. Asthma treatment Xolair (omalizumab) and psoriasis drug Raptiva (efalizumab) gained approval in 2003, followed by blockbuster Avastin (bevacizumab) for colon cancer and small-molecule Tarceva (erlotinib) for lung cancer in 2004. At the same time, the company's hugely successful monoclonal antibodies Herceptin (trastuzumab) and Rituxan (rituximab) showed efficacy for more indications.

Paying a premium for growth

The difference between Genentech the great company and the not-so-great stock starts with its status as a 'growth stock.' Growth stocks are those of companies whose revenues, accounting profits and free cash flow (the actual cash generated from sales minus expenses and capital investments, roughly) are expanding rapidly. Sustained growth is rare and investors will often pay a premium to own companies that offer it, expecting a greater return than from buying a stock market index fund or government bonds.

Investors pay for growth expecting a stock to climb from two causes: earnings rise and/or investors are willing to pay a greater premium for the shares. A stock selling for $100 with earnings of $5 a share has a price-to-earnings multiple of 20. If earnings grow to $10 a share and investors pay the same multiple, the stock rises to $200. Nice. But if earnings are flat and investors anticipate good times ahead, they may be willing to pay a higher multiple (higher premium) for the shares. If that's 30 instead of 20, the stock rises in this example to $150. If both earnings and multiples rise, much popping of champagne corks and planning for vacation homes. If neither happens, much pasta and potatoes, or worse.

The problem for investors willing to pay a premium today for Genentech is that the stock price reflects so much future earnings growth and such a high multiple that there is limited room to improve and greater risk of disappointment. Not good.

Valuation and competition

Genentech, which closed at writing at $53.60 a share, sells for roughly 50 times analysts' projected 2005 earnings per share of $1.11. That's 34% over 2004's projected $0.83. Because the multiple of 50 is greater than the 34% projected earnings growth, today's price includes substantial expectations for years ahead. This was all even headier when Genentech shares hit the upper $60s in April 2004, and more so today if you use other measures, such as free cash flow per share, instead of earnings.

I discussed this with analyst David Nierengarten, a full-time consultant to hedge fund Imagine Capital. In Nierengarten's view, even if everything were to go perfectly, Genentech shares would not be reasonably valued until 2010. Thus, the only way to make money at today's price is for Genentech's growth to increase even more. How likely is that?

“Currently a lot of Genentech's growth is driven by Avastin and other antibodies,” Nierengarten observes. “But there is small-molecule competition coming to market.” Small-molecule drugs are cheaper and easier to administer because they are pills.

“Every major pharma is working on small molecules that inhibit growth factors,” he cautions. As well as Genentech's partnered Tarceva, Nierengarten lists Novartis's (Basel, Switzerland; NYSE:NVS) PTK-787 (colon cancer), Pfizer's (New York, NY, USA; NYSE:PFE) SU11248 (kidney cancer) and GlaxoSmithKline's (Middlesex, UK; NYSE:GSK) lapatinib (breast and bladder cancer), which uses the same mechanism as Genentech's Herceptin. “Even if Genentech continues to get approvals, they won't get 100% of the market.”

Risk versus reward

The more your stock is priced to perfection, the less you have to gain and the more you have to lose. To buy Genentech stock priced at over 50 times earnings, while the company's Horizon 2010 plan projects 20% annual growth, means you buy estimated profits years ahead. Your risk is greater on the downside than upside, and even if you hold long enough for the risks to diminish, you have tied up your money for a number of years possibly to end with the same dollars or fewer than you started with. Most of us are not investors for that purpose. That's how a great company can become a bad stock.