How Morningstar Values Stocks

How cash flow analyses, uncertainty ratings, and economic moats play key roles in our equity valuation methodology.
By Jeremy Glaser |  26-04-13 | 

We've had some questions about how Morningstar's equity analysts come up with the fair value estimates for stocks they cover.'s markets editor Jeremy Glaser spoke with Matt Coffina, editor of Morningstar’s StockInvestor report in the U.S., who manages the Hare and Tortoise portfolios, using Morningstar’s valuation strategies.

Coffina, CFA, was previously a senior equity analyst with Morningstar and developed our valuation methodology, which is used by analysts globally to cover over 1,500 stocks.

In this interview, Coffina outlines what model Morningstar analysts use to ascertain stocks’ fair values, how they deal with uncertainty over their assumptions and how economic moats are built into our models.

Let's start at the beginning. What kind of model do our analysts use to come up with the fair value estimate or what they think that an individual stock is worth?

We use what's called the discounted cash flow model. The basic idea is we're thinking of a company as an owner of that company would. We're taking our best estimate of the future free cash flows that the company is generating.

So, free cash flow is basically the cash that's left over to provide a return to investors--creditors, debtholders, and equityholders--after you pay all the operating costs, capital expenditures, investments on working capital, and so on that a company needs to run its business and grow its business.

The cash flow that's left at the end, we're assuming that belongs to shareholders. And then what we're doing is adding up all of the future years' cash flows, except, while we're doing this, we're discounting those cash flows back to the present using a discount rate.

The reason you have to discount the cash flows is that cash in the future is worth less than cash that you have in your pocket today. The reason is pretty straightforward. If I have the cash today, I could invest it and earn interest or earn some investment returns, and also there is some possibility that that future cash flow will never be realized and so I need to be compensated for that risk.

Discounted cash flow models obviously aren't the only way to value stocks. Why do you think it's a superior one to, say, using a P/E multiple?

The advantage of discounted cash flow analysis is that it really allows you to incorporate any number of different circumstances or special situations. For example, if you wanted to use a P/E multiple but the company has a loss this year, well, how do you handle that situation?

Or, if the company is growing very quickly in the short term, what's an appropriate P/E multiple in that circumstance? It can be very hard to tell. And often the choice of a P/E multiple would be arbitrary based on where the company has traded historically, where comparable companies are trading, but it's not necessarily grounded in the future growth and cash flows of that company.

So, DCF we think is the most flexible approach. It allows you to account for special circumstances, allows you to incorporate multiple years of free cash flows. So, we're making usually explicit forecasts for at least five years on every individual financial statement line item; revenue, costs, and so on. And then also an important part of this is that it really lets you get at the drivers of valuation.

It helps you understand what's really important to the value of that company, where there is room for the company to be worth more or less than your base-case scenario depending on revenue or margins or whatever it is that's particularly important for that company that you are looking at.

How is the discounted cash flow model that Morningstar uses differ from a standard one?

I think the most distinctive feature of Morningstar's model is that we use a three-stage discounted cash flow model. So again, the analysts are making explicit forecasts for individual line items, things like revenue and operating costs only for the first five to 10 years of their forecasts.

Then we get into stage two, and stage two is really where our economic moat ratings come into play. So a company that is able to earn very high returns on capital, increase earnings relatively quickly, and do that for a sustained period of time is going to be worth more than a company that they can't do that.

So in general, a company with a wide moat would have the longest stage two, which again is a period during which the company is earning very high or relatively high returns on capital and perhaps growing faster than they otherwise would. And that's how the moat ratings come into our valuations.

In stage three, we're basically assuming that every company is the same, that returns on capital have converged to the cost of capital and no company is creating value during stage three.

If you're a company that's creating excess returns currently the longer you can put off stage three, the better. So again the wider the moat, the higher the fair value estimate, holding all else equal.

What are some of the drawbacks to this approach?

So, the problem with DCF, I think, is that it requires a lot of assumptions. There are a lot of inputs that go into these models, and the further out in time we go, the less likely we are to be right about those underlying assumptions.

So, it's much harder to predict what earnings are going to be five years from now than what they are going to be next year. The way that we handle this uncertainty really is through our margin-of-safety bands.

So, our analysts assign a fair value uncertainty rating to every company we cover, the lower the uncertainty, the more confidence we have in our fair value estimates, and the less of a discount we require to our fair value estimate before making a recommendation.

For example, company with low uncertainty we would only require a 20% discount to fair value before [it would receive a Morningstar Rating for stocks of 5 stars]. If the uncertainty rating were high then we require a 40% discount.

But by buying at a discount to fair value, there is room for our assumptions underlying that fair value estimates to be overly optimistic. We want to account for that possibility. Just in case we are being overly optimistic, we have that discount baked into the price that we are paying, and that gives us some confidence that the stock is really worth at least what we're buying it for.

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Hank Chess
Aug 23 2017 05:40 PM
 This posts explains this topic well
Manish Vaswani
May 6 2013 06:41 PM
 Dear Ganesh,

Thank you for going through the above article. Our estimated WACC, or discount rate, can be seen in our models. For retail customers or clients that don’t have access to our models, analysts are encouraged to include their WACC assumptions/fair value estimate in the valuation section of our reports.

Thanks and best regards,
Manish Vaswani
Equity Research Analyst
Morningstar India
Manish Vaswani
May 6 2013 06:34 PM
 Dear Nishith,

We are glad that you find the article informative; thank you for the same. As regards your queries, we derive discount rates from the weighted average cost of capital (WACC). WACC is calculated from the cost of equity and cost of debt weighted by each respective target contribution to a company’s overall capital structure. For example, if a company’s cost of equity is 10% and its cost of debt is 4% with a market value of equity and debt comprising 80%/20% of its capital structure, respectively, then the WACC is 0.8(10%) + 0.2(4%*(1-tax rate)). The tax rate adjustment for the cost of debt incorporates the tax benefit of debt interest payments. We use interest expense as a percentage of average debt outstanding as a proxy for cost of debt. For cost of equity, we determine a company’s level of systematic risk via sensitivity to overall GDP growth, operating leverage, and financial leverage. We generally categorize cost of equity into four buckets—below average at 8%, average at 10%, above average at 12%, and very high at 14%. We can also add country risk premiums depending on the primary location of a company’s operations.

Hope the above answers your queries.

Thanks and best regards,
Manish Vaswani
Equity Research Analyst
Morningstar India
Apr 29 2013 04:17 PM
Nishith Vyas
Apr 27 2013 02:51 PM
 Thanks a lot for this informative article. I would like to know the discount rate or range of discount rates that our morning star analysts use to arrive at the present value of the free cash flows. I would also like to know how morning star analysts arrive at those discount rates?
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