The Valuation Handbook: Valuation Techniques from Today's Top Practitioners

CHAPTER 12

Morningstar’s Approach to Equity Analysis and Security Valuation

 

Pat Dorsey

Director of Equity Research, Morningstar

 

 

At Morningstar, we take an unusual perspective toward equity analysis, relative to much of the industry. Instead of setting price targets and guessing what others might pay for a stock 12 months hence, we forecast cash flows and value businesses. In fact, our estimates of intrinsic value are the anchor for the five-star rating system we use for equities. If a company’s share price is roughly in line with our estimate of its intrinsic value, the stock receives a three-star rating—essentially a “neutral” or “hold.” When share prices diverge markedly from our estimates of intrinsic value, our ratings become more bullish or bearish.

We focus on intrinsic—rather than relative—valuation because it centers our thinking on the business that we are analyzing, as opposed to the market’s current opinion of that business. We use a discounted cash flow (DCF) approach to arrive at our intrinsic value estimates because it allows us to separate economic reality from accounting-based noise. Also, we believe that shareholder value creation is a more complex process than simply increasing earnings per share, and a cash flow-based approach lets us unpack concepts like growth, investment, and returns on capital.

By modeling the relationships between these three concepts, DCF allows our analysts to better understand the value drivers for the companies ...