How Morningstar Rates Stocks

Susan Dziubinski: Now for something that’s on our radar but at the same time completely different, Morningstar celebrates its 40th anniversary this week. It seems like an opportune time to take a step back and talk a little bit about Morningstar’s approach to stock investing. How would you say Morningstar’s approach differs from that of other firms analyzing stocks?

David Sekera: I think one of the biggest differentiators is our focus on investing for the long term. For most investors, the amount of time in the market is going to have a greater impact on your long-term success and building wealth as opposed to trying to time the market or trade individual stocks. Now, I’ve got nothing against trading individual stocks, but personally, I rarely pay attention to those underlying technical indicators.

Our focus here is on determining what we think the long-term intrinsic value of a company is. And then look for those situations where a stock is trading at a relatively large margin of safety below that valuation, and then we’ll let the market work itself out over time. The other part is, I think a lot of our job here is to filter out noise from signal to really help investors differentiate between what’s a catalyst that actually changes that long-term value of a company versus news that comes out that, while it may be interesting, isn’t necessarily meaningful to the value of a company. At the end of the day, our research and analysis is based on that bottom-up. long-term fundamental analysis with a focus on determining intrinsic value, which of course the definition of intrinsic value is the value of that stock based on the present value of the future free cash flow stream that company is going to generate over its lifetime.

Dziubinski: Dave, let’s do a rapid fire on some of Morningstar’s stock-related metrics. First, the Morningstar Economic Moat Rating. What is it and why does it matter?

Sekera: The economic moat rating, when I think about it, is just a very Warren Buffett or Graham and Dodd type of analysis. Does a company have long-term durable competitive advantages? And if so, how long is that company going to be able to generate excess returns on invested capital over its weighted average cost of capital before those excess returns get competed away by competition?

Of course, the longer a company can generate those excess returns, the more valuable that company is. When I think about it over the long term, I expect that companies with long-term durable competitive advantages are also going to be able to hold their value better to the downside. If we were to go into any kind of recessionary environment, I would expect that those without long-term advantages are going to be the ones that either leave that specific industry or could be a bankruptcy candidate as they’re unable to efficiently compete against those that do have those long-term competitive advantages.

Dziubinski: The Morningstar fair value estimate. How is it calculated and what does it tell investors?

Sekera: We use a full discounted cash flow model. Essentially what that means is that our equity analyst team, they’re going to forecast the revenue, the margins, and the earnings for each individual company over time that we cover. And they’re going to use those forecasts to project the amount of free cash flow that company is going to generate each year.

And then we’re going to take the present value of that to come up with what we think the intrinsic value of a company is. A lot of other firms are going to use different types of indicators or shorthand metrics, like a P/E ratio, to try and estimate the value of a stock.

Personally, I find that relying on P/E ratios is a poor indicator of valuation overall. And again, we could get into it in a longer discussion, but when I think about the P/E ratio, it doesn’t take into consideration a whole number of things, like it doesn’t take into consideration where we are in a business cycle. It doesn’t take into consideration when a company is going to grow and how long that growth is really going to last. Or conversely, maybe if there’s a contraction within the industry or that company’s business prospects. And it also doesn’t measure free cash flow, which again, that to me is really the true value of what a company is. So, in my opinion, net-net, P/E ratios I think are better used more for a relative value analysis than they are for really looking at the absolute value of a company.

Dziubinski: Now, the Morningstar Uncertainty Rating. Why does Morningstar think it’s important to consider the certainty with which our analysts calculate future cash flows and therefore their fair value estimates?

Sekera: When you think about the Uncertainty Rating, think about it as really a measure of the range of future potential cash flows of a company. I’d think about it this way: A company like a utilities company or maybe a company in a defensive sector such as Coca-Cola KO, they may have some short-term fluctuations in their business, but over time, they’re going to have relatively steady sales and margins.

But then companies like maybe a mining company in the basic-materials sector or a technology company that’s got some startup technology are going to have a much wider range of potential outcomes. That basic-materials company is going to have big swings over its business cycle. It’s going to have big swings based on whether we’re in an economic expansion or contraction.

And then same thing with a technology company with new tech, you could see a big upswing in revenue for a number of years. Or if competition comes in and their technology becomes outdated, you could see a big, sharp downturn in that company. Those are the companies that you’re going to have a much wider range or a much greater margin of safety before you’re going to be willing to invest in those.

Dziubinski: And then the Morningstar Rating for stocks, what does that represent?

Sekera: We use a scale of 1 to 5 stars to indicate how much we think a stock is either overvalued or undervalued as compared to its intrinsic value. So, for example, 1-star-rated stocks are those stocks that we think are most overvalued, and 5-star-rated stocks are those that are most undervalued. Now within the scale that we use for those star ratings, we do incorporate that Uncertainty Rating.

So, the greater the uncertainty, the more a margin of safety we’re going to want to see before recommending to buy that stock. But conversely, with the wide range of uncertainty, the more we’re going to let that stock rise above its fair value before we’d look to recommend to sell it. So, those Low Uncertainty Rated stocks, we actually have a much tighter range around fair value before we would recommend buying and selling that stock.

For a stock with 5 stars, that’s a stock that we would expect to be able to generate an above-average risk-adjusted return over a multiyear period, whereas those 1-star-rated stocks, that’s going to indicate a high probability of what we would expect for a lower risk-adjusted return over a multiyear time frame.

Dziubinski: We’ve covered a lot of ratings and metrics here, Dave. Should investors just buy 4- and 5-star stocks and then call it a day?

Sekera: Unfortunately, things aren’t quite that easy. So, the short answer is no. When I think about investing, it’s really an ongoing process of just continually incorporating new information as it comes out. Plus, you also have to watch what’s going on in the market. So, if you do look at a 4- or 5-star-rated stock, you buy some for your portfolio. If that stock does well, and it starts rallying and gets up into that 1- or 2-star-rated range, that’s probably a good time to maybe sell it or at least take some profit. Then from a fundamental perspective, investors just need to continually reassess what they think the intrinsic value of a company is, whether or not there have been any changes to their outlook that could change that valuation.

And, of course, if that valuation does change based on where the stock is trading, that may lead you to sell more or buy some more as well. So, for example, if there’s a catalyst that comes out, maybe that causes the stock to sell off, but yet your long-term thesis is still the same. That might be a good opportunity to buy some more, leverage into that position at a lower price. Or if you think the value of a company is actually less based on that catalyst, but the stock hasn’t fallen as much, that’s probably a good time to sell some of that stock.

This is an excerpt from the May 13, 2024, episode of The Morning Filter. Watch the full episode, 5 Cheap Stocks to Buy From an Attractive Part of the Market. See a list of previous episodes here.