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406-Using Morningstar's Rating for Stocks
  Course 406:
  Using Morningstar's Rating for Stocks
  
  
  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.