Morningstar's fair value estimate analysis is based on a different valuation methodology than ratio-based approaches. If you've ever talked about P/E or P/B (as we did in Stocks 108), you have valued stocks using ratios, also known as multiples. Investors like to use ratios because they are easy to calculate and readily available. The downside is that making sense of valuation ratios usually requires a bit of context. A company can have a high P/E or P/B but still be cheap based on fair value. If a computer company can grow fast enough, its stock will deserve a high P/E, and it might even be a bargain. Likewise, a company in a dying industry with negative growth may have a low P/E and still be overvalued.
We believe that looking at future profits allows for a more sophisticated approach to stock valuation. By determining a company's fair value based on a projection of a company's future cash flows, we can determine whether a stock is undervalued or overvalued. The advantage of this approach is that the result is easy to understand and does not require as much context as the basic ratios. While it takes more time and expertise to estimate future cash flows, we believe that valuing stocks in this way allows investors to spot bargains and make more intelligent investments.
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