Question: On Morningstar's individual stock pages, I see your analysts' fair value estimate for a stock, along with Consider Buying and Consider Selling prices. How do Morningstar analysts arrive at these numbers? Also, how do they relate to Morningstar's star ratings for stocks?
Answer: To determine a stock's fair value, Morningstar analysts examine factors such as estimated future cash flow, competitive positioning, and even the degree of certainty the analyst has in making his or her evaluation. Analysts from Morningstar's 125-person equity and credit research team use a standardized methodology to take them through this process for the more than 1,800 companies they cover worldwide.
Analysts typically are assigned to track the companies within specific sectors and revise their fair value estimates whenever information becomes available that affects their outlook for a stock. For example, a new product launch, a merger or acquisition, or a major competitor abandoning a market all could cause an analyst to revise a company's fair value estimate up or down.
As for how analysts arrive at a fair value estimate, and how a stock gets a given star rating, here's a breakdown of the process.
Company's Fundamentals
The first thing the equity analyst does is examine the company's fundamentals--sales, revenue, expenses, and so on--which are culled from financial statements, industry reports, discussions with company management, trade-show visits, and other sources.
Economic Moat Rating
Once the fundamental analysis is completed, the analyst proposes an “economic moat” rating for the stock. A company's economic moat is the degree to which it has sustainable competitive advantages over its competitors. For example, a wide-moat company may have an advantage over its competitors because it already dominates a marketplace and customers might be reluctant to switch vendors. Amazon.com (AMZN) has a wide-moat rating as a result of its current online retail dominance. Analysts propose a moat rating of wide, narrow, or none for a company, and the “moat committee”, composed of senior leaders within the equity research department, determines that rating.
Proprietary Discounted Cash Flow Model
Next, the analyst looks at historical data, along with the company's competitive position and future prospects, to forecast future cash flow. All this data is applied to a proprietary discounted cash flow model to arrive at a fair value estimate for the stock. Due to the specific characteristics of certain industries, special models exist for valuing banking and insurance companies as well as for real-estate investment trusts (REITs). This fair value estimate represents what Morningstar's equity analysts believe the stock is currently worth.
Fair Value Uncertainty Rating
Once the fair value estimate is established, the next step is to determine a level of confidence in the estimate, which can vary based on factors such as volatility within the company's industry, economic sensitivity, and other variables that could affect the stock's price in the future. The analyst assigns a fair value uncertainty rating of low, medium, high, very high, or extreme to the stock, which helps determine the margin of safety (or cushion to account for multiple potential outcomes) Morningstar's analysts believe is necessary to recommend buying or selling it. The upper and lower bounds of this margin of safety are determined by a formula that is applied to all stocks based on their uncertainty ratings. A stock with a low uncertainty rating requires a relatively low margin of safety. For example, a wide-moat company like Coca-Cola (KO), which has relatively predictable future cash flows, requires a premium or discount of about 20%-25% of its fair value estimate to be considered a sell or buy. But a stock with a much higher uncertainty rating and a greater range of reasonable potential outcomes—such as a life insurance company that carries risk from its investment portfolio and use of leverage--requires a premium or discount of 50%-75% to account for the level of unpredictability involved.
Morningstar Rating for Stocks
The last piece of the puzzle is the Morningstar Rating for stocks, which reflects where a stock's current share price stands relative to Morningstar's fair value estimate. A stock with a 5-star rating is selling at a deep discount while a stock with a 1-star rating is very overpriced, based on Morningstar's estimate. The 5- and 1-star thresholds are also the points at which the Consider Buying and Consider Selling prices kick in, respectively. A stock's star rating can change daily based on its closing price. For example, at one point during the market drop of 2008-09 more than 600 stocks were rated at 5 stars because their share prices had fallen so much relative to the analysts' fair value estimates. Today, fewer than 50 stocks carry this rating.
One more thing to remember about Morningstar's equity star ratings: Unlike Morningstar's fund and exchange-traded fund star ratings, which reflect an investment's past risk-adjusted performance relative to its peers, the equity star rating is a forward-looking measure based solely on a stock's current price relative to the analyst's estimate of its true worth.
Interpreting Consider Buying and Consider Selling Prices
Some of the Consider Buying and Consider Selling prices for stocks with high uncertainty ratings might look over-the-top, but Lauren DeSanto, COO of Morningstar's equity and credit research department, says these prices reflect the level of unpredictability involved in certain cases. "The range of outcomes is so broad in terms of the inputs to the valuation that investors need to take extra caution," she says.
DeSanto points to the market drop of a few years ago as evidence of how the system is designed to work. "It might seem like those Consider Buying and Consider Selling points aren't very meaningful at a time like this, when the market is pretty close to fairly valued," she says, "but that wasn't the case in 2008-09, for example. We had more stocks in the high uncertainty category then because macroeconomic (not just internal factors) can play a role. And with some nascent businesses, a higher uncertainty rating can be appropriate. A new, fledgling technology company would be a good example."
To read more about Morningstar's Equity Research Methodology, click here.
Data as of April 30, 2012.
