Course 401: The Morningstar Rating for Stocks
How We Assign Stars
In this course
1 Introduction
2 What Is Fair Value?
3 How We Assign Stars
4 Final Points

The Morningstar Rating for stocks measures whether a stock is over- or undervalued based on forward-looking estimates. Unlike the Morningstar star ratings for mutual funds, stock star ratings are not measures of past performance. Our analysts forecast how the company will do in the future, and we use those projections to derive a fair value.

We then calculate the star rating by comparing the stock's current market price with our fair-value estimate. Generally speaking, stocks trading at larger discounts to their fair values will earn higher star ratings. Not all companies are created equal, though. The required margin of safety (discount to our fair value estimate) gets larger as the quality of the company decreases.

We have included a risk adjustment, making it tougher for stocks with more business risk to earn 5 stars. The margin of safety we demand before giving a stock 5 stars is determined by our assessment of business risk. Our analysts assign stocks to one of three risk ratings: below-average, average, and above-average. For companies with below-average risk, we require a price that is at least 15% lower than the fair-value estimate before assigning 5 stars. This hurdle rate jumps to 36% for companies with above-average risk.

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," one that adequately compensates for the riskiness of the stock. Put another way, three-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 a "required return" because it represents the return an investor requires for taking on the risk of owning the stock.)

Five-star stocks, of course, should offer an investor a return that's well above the company's cost of equity, and high-risk 5-star stocks should 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 over the next three years, based on our assessment of the stock’s fair value.

For more specifics on expected returns and how they relate to our margin of safety requirements, see Pat Dorsey's recent article on our rating methodology.

Next: Final Points >>


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