The Morningstar Rating for stocks is based on a stock's market price relative to its estimated fair value, adjusted for risk. Generally speaking, stocks trading at large discounts to our analysts' fair value estimates will receive higher (4 or 5) star ratings, and stocks trading at large premiums to their fair value estimates will receive lower (1 or 2) star ratings. Stocks that are trading very close to our analysts' fair value estimates will usually get 3-star ratings.
Not all companies are created equal. As such, the discount required to our fair value estimate to get to 5 stars increases as the quality of a company decreases. We require smaller discounts for high-quality businesses because we are more confident about our cash-flow projections and in their fair values. The future is inherently uncertain, and that uncertainty is greater for some companies than others. Accordingly, we require larger discounts to our fair value for riskier or uncertain businesses.
When investing in any asset, you should expect a return that adequately compensates you for the risks inherent in the investment. Assuming that the stock's market price and fair value eventually converge, 3-star stocks should offer a "fair return." A fair return is one that adequately compensates you for the riskiness of the stock. Put another way, 3-star stocks should offer investors a return that's roughly equal to the stock's cost of equity. The cost of equity is often called the "required return," because it represents the return an investor requires for taking on the risk of owning a stock.
On the other hand, 5-star stocks should offer an investor a return that's well above the company's cost of equity. High-risk, 5-star stocks should also offer a better expected return than low-risk, 5-star stocks. Conversely, low-rated stocks have significantly lower expected returns. If a stock drops to 1 star, that means we expect it to lose money for investors based on our assessment of the stock's fair value.
It is important to remember that if a stock's market price is significantly above our fair value estimate, it will receive a lower star rating, no matter how wonderful we think the business or its management is. Even the best company is a poor investment if an investor overpays for its shares.
What Causes a Star Rating to Change? >>