How Morningstar Values Stocks

Matt, thanks for joining me today.

Matthew Coffina: Thanks for having me, Jeremy.

Glaser: Let's start at the beginning. What kind of model do our analysts use to come up with the fair value estimate or what they think that an individual stock is worth?

Coffina: We use what's called the discounted cash flow model. The basic idea is we're thinking of a company as an owner of that company would. We're taking our best estimate of the future free cash flows that the company is generating. So, free cash flow is basically the cash that's left over to provide a return to investors--creditors, debtholders, and equityholders--after you pay all the operating costs, capital expenditures, investments on working capital, and so on that a company needs to run its business and grow its business.

The cash flow that's left at the end, we're assuming that belongs to shareholders. And then what we're doing is adding up all of the future years' cash flows, except, while we're doing this, we're discounting those cash flows back to the present using a discount rate. The reason you have to discount the cash flows is that cash in the future is worth less than cash that you have in your pocket today. The reason is pretty straightforward. If I have the cash today, I could invest it and earn interest or earn some investment returns, and also there is some possibility that that future cash flow will never be realized and so I need to be compensated for that risk.

Glaser: Discounted cash flow models obviously aren't the only way to value stocks. Why do you think it's a superior one to, say, using a P/E multiple?

Coffina: The advantage of discounted cash flow analysis is that it really allows you to incorporate any number of different circumstances or special situations. For example, if you wanted to use a P/E multiple but the company has a loss this year, well, how do you handle that situation? Or, if the company is growing very quickly in the short term, what's an appropriate P/E multiple in that circumstance? It can be very hard to tell. And often the choice of a P/E multiple would be arbitrary based on where the company has traded historically, where comparable companies are trading, but it's not necessarily grounded in the future growth and cash flows of that company.

So, DCF we think is the most flexible approach. It allows you to account for special circumstances, allows you to incorporate multiple years of free cash flows. So, we're making usually explicit forecasts for at least five years on every individual financial statement line item; revenue, costs, and so on. And then also an important part of this is that it really lets you get at the drivers of valuation. It helps you understand what's really important to the value of that company, where there is room for the company to be worth more or less than your base-case scenario depending on revenue or margins or whatever it is that's particularly important for that company that you are looking at.

Glaser: How is the discounted cash flow model that Morningstar uses differ from a standard one?

Coffina: I think the most distinctive feature of Morningstar's model is that we use a three-stage discounted cash flow model. So again, the analysts are making explicit forecasts for individual line items, things like revenue and operating costs only for the first five to 10 years of their forecasts.

Then we get into stage two, and stage two is really where our economic moat ratings come into play. So a company that is able to earn very high returns on capital, increase earnings relatively quickly, and do that for a sustained period of time is going to be worth more than a company that they can't do that. So in general, a company with a wide moat would have the longest stage two, which again is a period during which the company is earning very high or relatively high returns on capital and perhaps growing faster than they otherwise would. And that's how the moat ratings come into our valuations.

In stage three, we're basically assuming that every company is the same, that returns on capital have converged to the cost of capital and no company is creating value during stage three. If you're a company that's creating excess returns currently the longer you can put off stage three, the better. So again the wider the moat, the higher the fair value estimate, holding all else equal.

Glaser: What are some of the drawbacks to this approach?

Coffina: So, the problem with DCF, I think, is that it requires a lot of assumptions. There are a lot of inputs that go into these models, and the further out in time we go, the less likely we are to be right about those underlying assumptions. So, it's much harder to predict what earnings are going to be five years from now than what they are going to be next year. The way that we handle this uncertainty really is through our margin-of-safety bands.

So, our analysts assign a fair value uncertainty rating to every company we cover, the lower the uncertainty, the more confidence we have in our fair value estimates, and the less of a discount we require to our fair value estimate before making a recommendation.

For example, company with low uncertainty we would only require a 20% discount to fair value before [it would receive a Morningstar Rating for stocks of 5 stars]. If the uncertainty rating were high then we require a 40% discount. But by buying at a discount to fair value, there is room for our assumptions underlying that fair value estimates to be overly optimistic. We want to account for that possibility. Just in case we are being overly optimistic, we have that discount baked into the price that we are paying, and that gives us some confidence that the stock is really worth at least what we're buying it for.

Glaser: Matt, thanks for your insight into our valuation process today.

Coffina: Thanks for having me, Jeremy.

Glaser: If you'd like to learn more about the process, Matt will be hosting a free Stock Valuation 101 webinar on April 29 at 4.15 EDT. For Morningstar, I'm Jeremy Glaser.