Finding Fair Value With Morningstar Ratings
Decoding the stars behind the stocks
Day 95
For beginner investors, one of the most challenging parts of stock investing is figuring out whether a stock is overvalued, undervalued, or fairly priced.
This is where Morningstar, my go-to investment research firm, can be an invaluable resource. Morningstar provides tools and ratings that simplify the process of evaluating stocks, helping investors make informed decisions without needing to be financial experts.
At the heart of Morningstar's stock analysis is their fair value estimate, which represents what their analysts believe a stock is truly worth based on its fundamentals. By combining this with their star rating system and other metrics like the economic moat rating, Morningstar gives investors a clear framework for assessing investment opportunities.
Let’s dive into how these tools work and why they’re so helpful.
Understanding Fair Value: The Core of Morningstar's Analysis
The fair value estimate is Morningstar's calculation of a stock's intrinsic worth. Unlike market prices, which fluctuate daily based on investor sentiment and short-term events, the fair value estimate focuses on long-term fundamentals.
Morningstar uses a discounted cash flow (DCF) model to calculate this value.
In simple terms, this model estimates how much cash a company will generate in the future and then discounts those cash flows back to today’s dollars to determine their present value. This approach helps investors focus on what a company is truly worth rather than being swayed by short-term market noise.
Why Fair Value Matters:
If a stock’s market price is below its fair value estimate, it may be undervalued and worth considering.
If the price is above its fair value estimate, it may be overvalued and less attractive as an investment.
This method provides a more reliable way to assess stocks compared to simpler metrics like the price-to-earnings (P/E) ratio.
The Star Rating System: A Beginner-Friendly Shortcut
To make fair value estimates even easier to use, Morningstar assigns each stock a star rating based on how its current market price compares to its fair value estimate. Here’s how it works:
5 Stars: The stock is significantly undervalued (potential buying opportunity).
3 Stars: The stock is fairly valued (neutral).
1 Star: The stock is significantly overvalued (likely overpriced).
This system simplifies decision-making for beginners by giving a quick snapshot of whether a stock might be worth buying, holding, or avoiding. However, it’s important to use this as a starting point for further research rather than relying on it alone.
Supplemental Tools: Economic Moat and Capital Allocation Ratings
While the fair value estimate and star rating are central to Morningstar’s analysis, they also provide additional metrics that can help you evaluate the quality of a company:
Economic Moat Rating
The economic moat rating measures how durable a company’s competitive advantage is. Companies with wide moats are better positioned to fend off competitors and maintain profitability over time. For beginners looking to invest in stable, long-term opportunities, focusing on wide-moat companies can be a smart strategy.
Morningstar identifies five sources of economic moats:
Network Effect: More users make the product or service more valuable (e.g., social networks like Facebook - META).
Intangible Assets: Patents or strong brands that protect profitability (e.g., Coca-Cola).
Cost Advantage: Ability to produce goods/services cheaper than competitors (e.g., Walmart).
Switching Costs: High costs for customers to switch to competitors (e.g., enterprise software like Microsoft).
Efficient Scale: Dominance in niche markets where competition would hurt profitability (e.g., utilities, railroads).
Capital Allocation Rating
This metric evaluates how effectively management uses resources to grow the business and reward shareholders. Ratings include:
Exemplary: Management consistently makes decisions that enhance shareholder value.
Standard: Decisions are generally sound but not exceptional.
Poor: Management often makes poor decisions that destroy shareholder value.
For beginners, this rating can help you avoid companies where poor management could hurt your investment.
Bringing It All Together
Morningstar’s tools are designed to make investing approachable for everyone—especially beginners who might feel overwhelmed by complex financial data. Here’s how you can use their framework:
Start with the fair value estimate and star rating to identify undervalued opportunities.
Use the economic moat rating as supplemental information to find companies with durable competitive advantages.
Review the capital allocation rating to ensure management aligns with shareholder interests.
By focusing on these metrics, you can build confidence in your investment decisions and avoid common pitfalls like chasing hype or overpaying for stocks. Whether you’re just starting out or refining your strategy, Morningstar provides an excellent foundation for smarter investing!
Before you leave, take a peek at my portfolio in the Morningstar dashboard so you can see it in action!
Keep walking!
Jeremy ✌️