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Morningstar.com's Interactive Classroom

Course 406
Using Morningstar's Rating for Stocks

Introduction

It's amazing how much attention some people pay to stock quotes, and how little they pay to the value of the underlying businesses they are buying.

At Morningstar, we evaluate stocks as pieces of a business and not as "little wiggling things with charts attached." We believe that purchasing shares of superior businesses at discounts to their fair values, and allowing those businesses to compound value over long periods of time, is the surest way to create wealth in the stock market.

The market may not always agree with our long-term investment philosophy, so sometimes our recommendations are out of step with consensus thinking. When stocks are high and richly valued, relatively few will receive the highest Morningstar Rating of 5 stars. But when the market tumbles, there will be many more 5-star stocks. We think good companies are more attractive when they are cheap than when they are expensive, so we find fewer opportunities when the market is overheating. If we wait to buy clothes and flat-panel televisions until they go on sale, why shouldn't we also purchase stocks at bargain prices?

Morningstar has been analyzing investment strategies for nearly 20 years, and we have become experts at separating successful styles from the mediocre majority. In this lesson, we will share our approach to rating stocks so that you have an opportunity to benefit from our investment strategy and build enduring wealth in the market.

What Is Fair Value?

Most any investment, whether it's buying a home or purchasing a stock, boils down to an initial outlay followed by (hopefully) a stream of future income. The trick is deciding on a fair price to pay for that expected stream of future income.

Let's say a stock trades at $20 per share. If you crunch the numbers--projected sales growth, future profit margins, and so on--you might estimate the stock's fair price per share to be $30. You pay $20 for the stock, and in return you receive a stream of income valued at $30. That's a great deal. If the stock was trading at $40, above the $30 fair value of the future income stream, you are looking at an expensive stock.

At Morningstar, our analysts estimate a company's fair value by determining how much we would pay today for all the streams of excess cash generated by the company in the future. We arrive at this value by forecasting a company's future financial performance using a detailed discounted cash-flow model (see Stocks 403) that factors in projections for the company's income statement, balance sheet, and cash-flow statement. The result is an analyst-driven estimate of the stock's fair value.

How Do We Assign Stars?

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?

Morningstar's stock star ratings are updated daily, and therefore they can change daily. The ratings can change because of a move in the stock's price, a change in the analyst's estimate of the stock's fair value, a change in the analyst's assessment of a company's business risk, or a combination of any of these factors. The Morningstar Rating for stocks includes a small buffer around the cutoff between each rating to reduce the number of rating changes produced by random market "noise." If a $50 stock moves up and down by $0.25 each day over a few days, the buffer will prevent the star rating from changing each day based on this insignificant change.

It is important to note that our fair value estimates do not change very often, but the market prices do. Therefore, stocks often gain or lose stars based just on movement in the share price. If we think a stock's fair value is $50, and the shares decline to $40 without a change in the intrinsic value of the business, the star rating will go up. Our estimate of what the business is worth hasn't changed, but the shares are more attractive as an investment at $40 than they were at $50.

A Different Valuation Approach&

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.

The Bottom Line

Above all, keep in mind that true investing means buying a stake in a superior business at a discounted price and allowing that business to compound in value over a long period of time. It isn't hopping on the latest hot concept hoping for a quick profit. That's why the Morningstar Rating for stocks does not attempt to prognosticate short-term price movements or momentum. We believe that the long-term value of a stock is tied to how much value the company generates for its shareholders.

Quiz 406
There is only one correct answer to each question.

1 The Morningstar fair value estimate represents which of the following?
a. How much the market expects you to pay for a stock.
b. A stock's current trading price plus its projected earnings growth.
c. An estimate of how much a stock should be worth today based on how much cash flow the company is expected to generate in the future.
2 If a stock has a Morningstar Rating of 3 stars, it is:
a. Overpriced.
b. Cheap.
c. Fairly valued.
3 For which risk level do we require the largest discount (margin of safety) for a stock to become 5 stars?
a. Below-Average.
b. Average.
c. Above-Average.
4 Five-star stocks should generate a return:
a. Greater than the company's cost of equity.
b. Equal to the company's cost of equity.
c. Lower than the company's cost of equity.
5 The Morningstar Rating for stocks:
a. Is based solely on sophisticated computer programs.
b. Is analyst-driven.
c. Takes momentum into account.
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