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Course 401
The Morningstar Rating for Stocks


In the Middle Ages, monks debated whether there was such a thing as a "just price," or an inherently correct price of a product--be it candles, wool, or a leg of lamb. Centuries later, Karl Marx and other economists argued that every product has an intrinsic value equal to the labor that went into making it. Such theories of natural, or just, prices have long since been discarded, except in one area: investing.

The theories actually make a great deal of sense when it comes to buying stocks. In fact, it’s the basis of the Morningstar Rating for stocks. In developing our stock rating, Morningstar mimicked the approach taken by a choice set of investors when they value stocks, investors of no less caliber than Warren Buffett of Berkshire Hathaway BRK.B, the managers of Clipper Fund CFIMX, and the leaders of Tweedy, Browne, among others. They all use fair value (the investing equivalent of the just price) to find attractive stocks. When a stock trades for less than its fair value, they pounce.

What Is Fair Value?

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

Let's say a stock trades for $20 per share. If you crunch the numbers--projected sales growth, future profit margins, and so on--you might estimate the stock's fair value per share to be $30. That's a good deal. You pay $20 to buy the stock, and in return you receive a stream of income valued at $30. If instead of $30 the fair value per share had been $10, you're looking at an expensive stock.

No number, fair value included, can mechanically pick winning stocks. But the Morningstar Rating for stocks allows us to drain the most expensive stocks from the lake of possible investments, thereby creating a wading pool of possible bargains.

How We Assign Stars

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.

Final Points

Note how our fair-value analysis differs from just looking for stocks with low price/earnings or low price/book-value ratios. 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. Looking at future profits allows for a more sophisticated approach to stock valuation.

Just as important, the Morningstar Rating for stocks does not attempt to take investor sentiment into account, and therefore does not factor in a phenomenon like "momentum" (whether a stock is currently rising or falling--which some investors use as a short-term trading signal). We don't deny that investor sentiment can play a very large role in the near-term value of a stock. But we believe that the long-term value of a stock is tied to how much value the company generates for its shareholders.

True investing means buying a stake in a business at a good price. It isn't hopping on the latest hot concept hoping for a quick profit.

Quiz 401
There is only one correct answer to each question.

1 Fair value is:
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 the company is expected to grow in the future
2 If a stock has a Morningstar Rating of three stars, it is:
a. Overpriced
b. Cheap
c. Fairly valued
3 For which risk level do we require the largest 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. Below 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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Copyright 2006 Morningstar, Inc. All rights reserved.
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