The Morningstar Rating for Stocks is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value. Our rating system also includes an uncertainty adjustment, so that it's more difficult for a company to earn a 5-star rating the more uncertain we are of our fair value estimate.
Under our system, 3-star stocks are those that should offer a "fair return," one that adequately compensates for the riskiness of the stock. Three-star stocks should offer investors a return that's roughly comparable to the stock's cost of equity. (The cost of equity is often called a "required return" because it represents the return an investor requires for taking on the risk of owning the stock.)
Five-star stocks, of course, should offer an investor a return that's well above the company's cost of equity. Conversely, low-rated stocks have significantly lower expected returns.
The Morningstar Rating for Stocks also 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.
Benefits
The Morningstar Rating for stocks:
Provides an indication of whether a stock is over- or undervalued based on the forward-looking estimates of Morningstar's equity analysts.
Offers up-to-date, daily insight into the valuation of 2000 companies
Leads investors to well-run businesses trading at reasonable prices—not simply to fads or "story stocks."
Origin
Morningstar generates this information in-house for about 2000 stocks. Ratings are updated daily, based on the closing price of each stock. The star rating can change because the analyst changes the fair value or the fair value uncertainty rating of the stock, or because the price of the stock changes. Our rating is unique in that a sudden price change immediately triggers a rating change. (If the analyst needs time to incorporate new information into the valuation model, we put the rating "under review" until the new fair value is published.)
Note: In order to reduce the number of rating changes due to small fluctuations in the stock price, we have a small buffer around the cutoffs between any two ratings. The buffer prevents the rating from flip-flopping back and forth between adjacent star ratings based simply on small fluctuations in the price.
For the Pros
Determining Fair Value
Our analysts use a standardized, proprietary valuation model to assign fair values. Our model has three distinct periods:
the first five years,
year six to perpetuity,
and perpetuity
By summing the discounted free cash flows from each period, we arrive at an enterprise value for the firm. Then, by subtracting debt and adjusting for any off-balance-sheet assets or liabilities, we arrive at a fair value of the common stock. We describe the model's key features below.
First Stage - The First Five Years
Our analysts make detailed forecasts of each company's performance over the next five years, including revenue growth, profit margins, tax rates, changes in working-capital accounts, and capital spending. This five-year period is the first stage of our model.
Second Stage - Year Six to Perpetuity
The length of the second stage depends on the strength of the company's economic moat. Economic moat is a term used by Warren Buffett to describe the predictability and sustainability of a company's future profits. The competitive forces in a free-market economy will tend to chip away at above-average returns on invested capital (ROICs). If a company earns a high ROIC, it attracts competitors, which then capture a portion of those excess returns. Only companies with wide economic moats - something inherent in their business that competitors cannot replicate - can hope to keep these competitive forces at bay for a prolonged period.
We define the second stage of our model as the period it will take for the company's marginal ROIC - the return on capital for the last dollar invested - to decline (or rise) to its cost of capital. We forecast this period to be anywhere from five years (for companies with no economic moat) to 20 years (for wide-moat companies). During this period, we forecast cash flows using three assumptions: an investment rate in year five; ROIC in year six; and years to perpetuity. The investment rate and marginal ROIC will decline smoothly until the perpetuity year. In the case of firms not earning their cost of capital, we assume marginal ROICs rise to the firm's cost of capital.
Third Stage - Perpetuity
Finally, once a company’s marginal ROICs hit its cost of capital, we assume it remains in this "perpetuity” state forever. At perpetuity, the return on new investment is set equal to the firm’s weighted average cost of capital (WACC), which is our discount rate. At this point we believe the firm will no longer be able to earn a profit greater or less than its cost of capital. The company could be generating significant free cash flow—the more free cash flow, the higher the fair value—but any additional capital invested in the business adds no value. Thus, our fair value for a stock is the sum of the cash flows from years 1-5, the cash flows during the interim period, and the perpetuity value, all discounted to present value using the WACC.
For financial companies such as banks, insurance firms, and REITs, we use different valuation models. The guiding principles are the same, but the calculations are different.
Discount Rates
In deciding the rate to discount future cash flows, we ignore stock-price volatility (which drives most estimates of beta) because we welcome volatility if it offers opportunities to buy a stock at a discount to fair value. Instead, we focus on the fundamental risks facing a company's business, such as the degree of financial leverage and the volatility of cash flows.
Hidden Assets/Liabilities: Options, Pensions, Etc.
In arriving at our fair value estimate, we also add back any hidden assets and subtract out hidden liabilities. Hidden assets might include real estate that's undervalued on the firm's books. Hidden liabilities mainly include underfunded pension obligations and the cost of stock-option grants. We feel that employee stock options represent a real cost to existing shareholders, and must be deducted from fair value.
Fair Value Uncertainty
To generate the Fair Value Uncertainty Rating, analysts consider factors such as sales predictability, operating leverage, financial leverage, and a firm’s exposure to contingent events. Analysts then classify stocks into one of several uncertainty levels: Low, Medium, High, Very High, or Extreme. The greater the level of uncertainty, the greater the discount to fair value required before a stock can earn 5 stars, and the greater the premium to fair value before a stock earns a 1-star rating.
See Also