Show

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. Ideally, we'd like our discount rates to reflect the risk of permanent capital loss to the investor.

When assigning a cost of equity to a stock, our analysts score a company in the following areas:

Free Cash Flows: The higher as a percentage of sales, the better.
Debt Leverage: The lower the debt leverage, the better.
Cyclicality: The less cyclical the firm, the better.
Size: We penalize small firms.

We set the average cost of equity at 10.5%, which corresponds to a risk-free rate of 5.5% and an equity-risk premium of 5%. Based on how each company scores based on the fundamental risk factors outlined above, we assign it a higher or lower cost of equity. As of January 2004, our cost of equity ranged from 8% to 15%.

Because we are valuing the cash flows to both equity and debt holders, we use the weighted average cost of capital (WACC) for our discount rate. For the cost of debt, we typically use the higher of a) interest expenses as a percentage of outstanding debt, b) current yields on the firm’s outstanding bonds.

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.

This is one of the three components that make up the Morningstar Rating for stocks (the other two being our analysts' determination of business risk and the stock's current market price).