Bob's is only one of a number of requests we've received lately for a more detailed explanation of how we assign a stock's fair value. That's a reasonable thing to ask, since those fair value estimates are a crucial part of the Morningstar Rating for stocks, which I discussed last week
. Here's what you need to know:
The Essentials of Fair Value
We estimate the fair value of each stock using a discounted cash flow (DCF) model which we developed in-house at Morningstar. Such models assume that the value of a stock is equal to the total value of the profits it's expected to generate in the future, discounted back to the present. We like DCF models because they treat each company as a business rather than a little wiggly line on a stock chart, and they force an analyst to think through all the factors that will affect a company's performance. (For more on DCF models versus more traditional valuation methods such as price/earnings ratio, check out my article "Putting a Price Tag on Hard-to-Value Stocks"
But any DCF model is only as good as the numbers you put into it, which is why we've tried to make our model as thorough as possible. First, an analyst enters the company's historical data for the past five years into a spreadsheet, including dozens of different data points. These include basic information such as sales, cost of goods sold, inventories, and long-term debt, as well as more esoteric items such as deferred income tax expense and capitalized lease obligations. Most of this historical data doesn't directly affect the fair value (which is based on future
cash flows), but it provides a very useful context for projecting future results.
Those projections are the meat of our model, and they're determined by the analyst based on his or her knowledge of the company and its competitive position. If the analyst thinks profit margins will expand, or sales growth will slow dramatically, or the company will increase its capital expenditures, the model can reflect those predictions. Beyond five years, our model assumes that growth and profitability will regress to the market average over a period determined by the analyst, typically zero to 15 years. The end result is a projection of how much free cash flow (operating cash flow minus capital expenditures) the company will generate over the next five to 20 years.
Enter Cost of Capital
We're not done yet. To figure out what these cash flows are worth today, we have to discount them back to the present using the firm's cost of capital. (For a refresher course on what discounting is and why it's necessary, see "The Time Value of Money"
.) We also use the cost of capital to figure out the firm's "perpetuity value," or its residual value after it's done regressing to the mean. Adding up the present values of all the estimated future free cash flows, plus the perpetuity value, gives our estimate of the company's total value. Dividing this number by shares outstanding gives the fair value per share--the number you see on Morningstar.com (if you're a Premium Member
But where does the cost of capital come from? That's a crucial question, because a swing of just one or two percentage points can make a significant difference in a company's fair value. That's especially true for companies whose value lies almost completely in the future. For example, I cover Amazon.com , and I estimate its fair value to be $13 per share, based on a cost of capital of 10%. If I raised Amazon's cost of capital to 11%, its fair value would fall to $10 per share--a difference of almost 25%.
Our analysts ultimately determine each company's cost of capital themselves, but they do so using some guidelines. Riskier companies have a higher cost of capital than staid, boring ones, for the same reasons that risky borrowers have to pay higher interest rates on loans. We internally estimate a minimum cost of capital for each company using a variety of risk factors, but analysts can use a higher number if they know of additional risks that aren't captured by the estimate. Each Morningstar analyst has to be able to defend his or her fair value estimates in detail before a team of senior analysts and editors.
There's more to our model than I've described here, but this should give you an idea of the basics. As you can see, estimating a stock's fair value is as much an art as a science, but we think the system we've come up with is a good one. Even if we end up being wrong about a stock's value, the transparency of our model allows us to pinpoint exactly which of our assumptions went astray--which in turn gives us a better idea of what to look for in the future.