To arrive at our fair value uncertainty ratings, we'll be looking at four things, all of which affect the dispersion of possible fair values.
Our first step is thinking about the likely range of sales for a company. Some businesses--such as grocery stores or consumer product companies--have fairly predictable sales, while many others have revenue lines that can swing around quite a bit.
The second closely related step is thinking about a company's operating leverage. What percentage of each incremental dollar of sales becomes income? The key to this question will be a company's mix of variable relative to fixed costs.
We'll also take financial leverage into account, because even a steady business can have an uncertain future for shareholders if it has too much debt. Bondholders always get their money first, after all, and financial leverage can amplify equity returns in both directions.
And finally, we'll consider whether a specific event in the future, such as a product approval or legal decision, could radically change a company's value. It's important to note that sales variability and operating leverage work together. A company with sales that don't fluctuate very much, but which has high fixed costs--such as a grocery store--might have the same level of uncertainty as a company with more-variable sales but costs that can ebb and flow with the business, such as a consulting firm.