Adam Zoll, assistant site editor with Morningstar.com, provides an answer.
To determine a stock's fair value, Morningstar analysts examine factors such as estimated future cash flow, competitive positioning, and even the degree of certainty the analyst has in making his or her evaluation.
Analysts use a standardised methodology to take them through this process. However, they revise their fair value estimates whenever information becomes available that affects their outlook for a stock. For example, a new product launch, a merger or acquisition, or a major competitor abandoning a market all could cause an analyst to revise a company's fair value estimate up or down.
As for how analysts arrive at a fair value estimate, and how a stock gets a given star rating, here's a breakdown of the process.
Step I: Company's fundamentals
The first thing the equity analyst does is examine the company's fundamentals--sales, revenue, expenses, and so on--which are culled from financial statements, industry reports, discussions with company management, trade-show visits, and other sources.
Steo II: Economic moat rating
Once the fundamental analysis is completed, the analyst proposes an economic moat rating for the stock. A company's economic moat is the degree to which it has sustainable advantages over its competitors. A wide-moat company might have a built-in advantage, for example, because no one else can touch its low prices or because it already dominates a marketplace and customers might be reluctant to switch vendors. For instance, in the U.S., Amazon.com has a wide-moat rating as a result of its online retail dominance.
Analysts propose a moat rating of wide, narrow, or none for a company, and the moat committee, composed of senior leaders within the equity research department, determines that rating.
Read How important is an economic moat in stock picking?
Step III: Discounted cash flow
Next, the analyst looks at historical data, along with the company's competitive position and future prospects, to forecast future cash flow. All this data is applied to a proprietary discounted cash flow model to arrive at a fair value estimate for the stock.
Due to the specific characteristics of certain industries, special models exist for valuing banking and insurance companies. This fair value estimate represents what Morningstar's equity analysts believe the stock is currently worth.
Step IV: Fair value uncertainty rating
Once the fair value estimate is established, the next step is to determine a level of confidence in the estimate, which can vary based on factors such as volatility within the company's industry, economic sensitivity, and other variables that could affect the stock's price in the future.
The analyst assigns an fair value uncertainty rating of low, medium, high, very high, or extreme to the stock, which helps determine the margin of safety (or cushion to account for multiple potential outcomes)Morningstar's analysts believe is necessary to recommend buying or selling it. The upper and lower bounds of this margin of safety are determined by a formula that is applied to all stocks based on their uncertainty ratings. A stock with a low uncertainty rating requires a relatively low margin of safety. For example, a wide-moat company like Coca-Cola, which has relatively predictable future cash flows, requires a premium or discount of about 20%-25% of its fair value estimate to be considered a sell or buy. But a stock with a much higher uncertainty rating and a greater range of reasonable potential outcomes--such as MetLife, which, like many life insurance companies, carries risk from its investment portfolio and use of leverage--requires a premium or discount of 50%-75% to account for the level of unpredictability involved.
Rating for stocks
The last piece of the puzzle is the Morningstar Rating for stocks, which reflects where a stock's current share price stands relative to Morningstar's fair value estimate. A stock with a 5-star rating is selling at a deep discount while a stock with a 1-star rating is very overpriced, based on Morningstar's estimate.
Read What's the difference between fair value and target price?
