Morningstar equity analysts always refer to the stocks Fair Value Estimate, or FVE. According to the latest analysis, the FVE of Infosys, TCS and Wipro are Rs 1,140, Rs 2,625 and Rs 325 respectively.
How do I use this data?
The FV for stocks helps investors determine whether a stock is trading at, below, or above its FVE, as determined by Morningstar's equity analysts.
The analysts forecast a company's future cash flows to arrive at an estimate of the company's intrinsic worth. If the FVE for the stock, based on the analysts' estimate of the company's intrinsic worth and the number of shares outstanding, is Rs 100 per share but the stock is trading at only Rs 90 per share, then it is trading at a discount to its FV; a FV higher than the stock's trading price suggests it is trading at a premium to its FV.
Along with the stock's FVE, the Analyst Report page also includes "Consider Buy" and "Consider Sell" prices based on what our analysts consider to be a suitable margin of safety for buying or selling the stock. For stocks with higher FV uncertainty ratings (in which future earnings are more difficult to estimate), this margin of safety is rather broad, whereas for those with narrow uncertainty ratings (in which future earnings are considered more knowable), the margin of safety is more narrow.
The FVE is a great tool to assess whether a stock is trading at, above, or below what our analysts think it's worth and to identify stocks that may be mispriced. But it's not a crystal ball. It is an estimate and should be used as such.
Why and when does Morningstar change fair value estimates for stocks?
There are many reasons why analysts might make a change to our FVE. It could be the result of a small tweak to our model based on a time-value-of-money update, or an increase or decrease in the underlying inputs in our model based on new information revealed in quarterly earnings reports. Alternatively, it could be new information that causes them to re-evaluate their near-term or long-term thesis.
Some wonder why our FVE for a stock ticks up a bit from year to year, even when our forecast for the company isn't changing. When you see a company's FVE has moved upward steadily in small increments over the years, many times it is due to an adjustment for the time value of money.
Morningstar's philosophy of stock investing is that a firm's intrinsic worth, or fair value estimate, is equal to the value of the cash the business can generate in the future. But the cash that is generated today is worth more to investors than the cash that could be generated in the future due to the uncertainty that the business will actually deliver those results. And if you give up a rupee today to buy that future cash flow, you have the opportunity costs of using that rupee to invest in other, potentially safer assets.
For this reason, we apply a discount rate to those future cash flows to account for these unknowns. But the key driver for most firms is the cost of equity, or what return shareholders demand on an average, annualized basis (not adjusted for inflation) to hold the shares. Unlike a bond yield, the cost of equity can't be observed directly; however, we have a process to estimate it based on a number of factors that look to capture the risk characteristics of various businesses. In short, the riskier the company, the higher the cost of equity should be.
Why does this lead, all else being equal, to FVE going up every year by the cost of equity (net of the shareholder return allocated to dividends)? Essentially, at the end of the year all of those cash flows that the analyst had predicted have now actually been realized by the business and no longer need to be discounted as the uncertainty is gone and the cash is now in hand. (Note that dividends need to be excluded here because those are payouts that are in the hands of shareholders of the time of the payment and are no longer available to the company).
In other words, holding the FVE steady over a multiyear period would imply that a company's cash flows have been coming in below our expectations.
Sometimes the information in a quarterly earnings release causes us to re-evaluate our forecast for a company's near- or long-term prospects.
As we incorporate more-optimistic assumptions into our model, it could result in an upward revision to our FVE. For example, Brian Colello, Director of Tech, Media & Telecom Equity Research at Morningstar, raised the FVE of Apple by about 5% to $145 from $138, driven by improved iPhone pricing and gross margin assumptions.
On the other hand, when Twitter reported disappointing 4th quarter 2016 results, with total revenue and operating income below our expectations, equity analyst Ali Mogharabi noted that "while the firm's growing user engagement is reaffirming part of our thesis, lower-than-expected user growth and delay in more effective monetization of the users are concerning." He lowered Twitter's FVE to $18 from $20 given questions surrounding the company's ability to grow its user base. It was again lowered to $17 but after the 2nd quarter 2017 results, the analyst is maintaining the FVE. He explains that despite the lack of growth in monthly active users, continuing growth in user engagement was encouraging and the company showed its ability to monetize the intangible asset, which is user behaviour data that it compiles.
Also, when companies are being acquired, we often update our FVE to the takeout price.
We also include the probability of certain macroeconomic and political events; these forecasts can also impact a company's FVE.
Source: Putting FVE in context / Why do stocks’ FVE change? / Apple results / Twitter results
