Morningstar’s Equity Analysts apply a consistent, forward-looking, and proven global methodology that focuses on long-term fundamental valuation, competitive advantages (economic moats), risk, financial health, and stewardship. Our bottom-up approach includes site visits and frequent interactions with company management and other industry participants to foster deeper analytical insights.
We evaluate stocks for what they truly are--pieces of a business. Instead of prognosticating short-term price movements or momentum, our analysts focus on determining the value of a business, its risks, and whether the stock price accurately reflects both the value and risk.
Simply put, we look for superior businesses that trade at discounts to their fair values. The market, of course, doesn't always agree with us, so sometimes our recommendations are out of step with consensus thinking. But we believe this approach is the most sensible way to create wealth over the long term.
Determining Fair Value
This philosophy of fundamental research is the foundation for our valuation model. We believe that:
- How much capital a company invests and what it earns on that capital drive shareholder value.
- Free cash flow--not reported earnings--is what counts.
- As Warren Buffett has said, "Growth is always a component in the calculation of value--sometimes a positive, often a negative." If a company can't earn its cost of capital, growth destroys value instead of creating it.
- Competitive advantages disappear over time.
- It's dangerous to assume that the future will be better than the past.
These core beliefs guide our stock analysts as they estimate future cash flow, using their in-depth knowledge of each company and its competitive position within its industry. Our analysts forecast revenue growth, profit margins, and capital investment (and all of the numbers that go into them) for each firm they cover.
Their forecasts for each company populate our discounted cash flow model, which calculates the present value of the company's future discretionary cash flow based on its cost of capital, as determined by our analysts.
A Margin of Safety
Estimating fair values is no easy process, and we don't presume we'll always be right. So we look for stocks with a deep enough discount to our fair value to offer a reasonable margin of safety--something recommended long ago by Benjamin Graham. Even if we're wrong about our fair value estimate, there is a cushion for investors.
The discount required to earn our highest rating depends on the quality of the company. We believe investors are better served paying a fair price for a firm with great long-term prospects--one that creates economic value--than a "cheap" price for a wealth-destroying company.
One thing we look for is an "economic moat
," an ability to keep competitors at bay via factors such as high switching costs for customers, patents or copyrights, or being a low-cost producer. In general, the wider the economic moat and the lower the risk of the business, the smaller the discount we demand before recommending a stock as a sound investment.
We track the 5,800 stocks that trade on the major U.S. exchanges. For each one, we list more than 250 data points and produce daily HTML Reports and one-page PDF data reports. And we give proprietary Morningstar financial grades for profitability, growth, and financial health for 90% of these stocks.
gain access to research from our team of stock analysts. Our analysts prepare detailed Analyst Reports for the most widely held stocks. These analyses include rigorous cash flow models that drive our valuation appraisals and star ratings. This coverage is supplemented with event-driven Stock Analyst Notes. All of this information is compiled in a five-page PDF report. We update our star ratings every trading day.
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by Pat Dorsey, Director of Stock Analysis