Morningstar analysts believe that a company’s intrinsic worth results from the future cash flows it can generate. The Morningstar Rating for stocks identifies stocks trading at a discount or premium to their intrinsic worth – or fair value estimate, in Morningstar terminology. Five-star stocks sell for the biggest risk-adjusted discount to their fair values, whereas one-star stocks trade at premiums to their intrinsic worth.
Four key components drive the Morningstar rating: our assessment of the firm’s economic moat, our estimate of the stock’s fair value, our uncertainty around that fair value estimate and the current market price. This process ultimately culminates in our single-point star rating. Underlying this rating is a fundamentally focused methodology and a robust, standardised set of procedures and core valuation tools used by Morningstar’s equity analysts.
What is an Economic Moat?
The concept of the Morningstar Economic Moat Rating plays a vital role not only in our qualitative assessment of a firm’s investment potential, but also in our actual calculation of our fair value estimates. We assign three moat ratings – none, narrow, or wide – well as the Morningstar Moat Trend Rating – positive, stable, or negative – to each company we cover.
Companies with a narrow moat are those we believe are more likely than not to achieve normalized excess returns on invested capital over at least the next 10 years. Wide-moat companies are those in which we have very high confidence that excess returns will remain for 10 years, with excess returns more likely than not to remain for at least 20 years. The longer a firm generates economic profits, the higher its intrinsic value.
The assumptions that we make about a firm’s economic moat play a vital role in determining the length of “economic outperformance” that we assume in the terminal sections of our valuation model. To assess the sustainability of excess profits, analysts perform ongoing assessments of what we call the moat trend.
A firm’s moat trend is positive in cases where we think its sources of competitive advantage are growing stronger; stable where we don’t anticipate changes to competitive advantages over the next several years; or negative when we see signs of deterioration.
At the heart of our valuation system is a detailed projection of a company’s future cash flows. The first stage of our three-stage discounted cash flow model can last from five to 10 years and contains numerous detailed assumptions about various financial and operating items. The second stage of our model – where a firm’s return on new invested capital (RONIC) and earnings growth rate implicitly fade until the perpetuity year – can last anywhere from one year (for companies with no economic moat) to 10-15 years (for wide-moat companies).
In our third stage, we assume the firm’s RONIC equals its weighted average cost of capital, and we calculate a continuing value using a standard perpetuity formula. In deciding on the rate at which to discount future cash flows, we use a building block approach, which takes into account expectations for market real return, inflation, country risk premia, corporate credit spread, and any additional systematic risk. We also employ a number of other tools to augment our valuation process, including scenario analysis, where we assess the likelihood and performance of a business under different economic and firm-specific conditions.
Our analysts model three scenarios for each company we cover, stress-testing the model and examining the distribution of resulting fair values. The Morningstar Uncertainty Rating captures the range of likely potential fair values and uses it to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system.
How Certain are Analysts?
The Uncertainty Rating represents the analysts’ ability to bound the estimated value of the shares in a company around the Fair Value Estimate, based on the characteristics of the business underlying the stock, including operating and financial leverage, sales sensitivity to the overall economy, product concentration, pricing power, and other company-specific factors.
Our corporate Stewardship Rating represents our assessment of management’s stewardship of shareholder capital, with particular emphasis on capital allocation decisions. Analysts consider companies’ investment strategy and valuation, financial leverage, dividend and share buyback policies, execution, compensation, related party transactions, and accounting practices. Corporate governance practices are only considered if they’ve had a demonstrated impact on shareholder value. Analysts assign one of three ratings: “Exemplary,” “Standard,” and “Poor.” Analysts judge stewardship from an equity holder’s perspective.
Ratings are determined on an absolute basis. Most companies will receive a Standard rating, and this is the default rating in the absence of evidence that managers have made exceptionally strong or poor capital allocation decisions.
