The Morningstar Rating for Stocks is calculated by comparing a stock´s current market price with Morningstar´s estimate of the stock´s fair value. Our rating system also includes a risk adjustment, so that it´s more difficult for a company with above-average business risk to earn a 5-star rating.
The margin of safety we demand before giving a stock 5 stars is determined by our assessment of business risk. Our analysts assign stocks to one of three business risk ratings. We make it tougher for stocks with above-average business risk ratings to earn 5 stars.
Each of the five star-rating levels is defined based on expected returns, which assume that the stock´s market price and fair value eventually converge. Under our system, 3-star stocks are those that should offer a "fair return," one that adequately compensates for the riskiness of the stock. Three-star stocks should offer investors a return that´s roughly comparable to the stock´s cost of equity. (The cost of equity is often called a "required return" because it represents the return an investor requires for taking on the risk of owning the stock.)
Five-star stocks, of course, should offer an investor a return that´s well above the company´s cost of equity, and high-risk 5-star stocks should offer a better expected return than low-risk 5-star stocks. On average, we expect 5-star stocks with below-average risk to return at least 15.5% annualized over the next three years. Because the hurdle rate for stocks with above-average risk is higher, we´d expect a 30.5% annualized return for a 5-star stock with above-average risk. Conversely, low-rated stocks have significantly lower expected returns. If a stock drops to 1 star, that means we expect it to lose money for investors over the next three years, based on our assessment of the stock´s fair value.
The Morningstar Rating for Stocks also includes a small buffer around the cutoff between each rating, to reduce the number of rating changes produced by random market "noise." If a $50 stock moves up and down by $0.25 each day over a few days, the buffer will prevent the star rating from changing each day based on this insignificant change.
