Guide To Morningstar’s Equity Research Methodology

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Guide to Morningstar’s Equity Research MethodologyContents1 Morningstar Equity Research Overview3 Introduction to Morningstar Ratingfor StocksThe Morningstar Economic Moat Rating4 Determining Fair ValueThe Uncertainty RatingGenerating the Star Rating5 Stewardship Grade6 Morningstar Analyst Team7 Morningstar Equity Analyst ReportTMTMMorningstar Equity Research OverviewMorningstar is a leading provider of independent investment research currently serving clientsglobally through our presence in North America, South America, Europe, Asia, and Australia.Our broad coverage extends to 120 equity and credit analysts and strategists who cover more than1,400 companies across the globe. Morningstar is not involved in banking or brokerage activities—our business is solely research—so our analysis is independent and objective. Morningstar’s equity research department is organized by sector. Our analyst staff travels frequentlyto meet with companies and attend conferences to deepen their knowledge, and most of ouranalysts are based in Chicago, Amsterdam, Sydney, Hong Kong, and Shenzhen. Our analysts have anaverage of more than ten years of experience in the financial services industry, and more than 60%of them have an M.B.A., a CFA charter, or both. Every analysis we publish is vetted by our staff toensure our investment philosophy and process is consistent company-wide.Exhibit 1 Morningstar Wide Moat Focus IndexSM vs. S&P 500Morningstar Wide Moat Focus Index SMTrailing Annualized Returns (%)S&P 8200920102011201220132014Morningstar’s equity research team keeps a consistent focus on economic moats and intrinsic valueapplied across a large global coverage universe. Our emphasis on analyzing competitive advantagesis the cornerstone of Morningstar’s methodology. Within this framework and by using our proprietary

Page 2 of 9Guide to Morningstar’s Equity Research Methodology3 three-stage free cash flow model, each stock within our universe is assigned a fair value estimate.3 We then assign an uncertainty rating based on multiple fundamental factors, which dictates the3 appropriate margin of safety required before recommending the stock.Morningstar’s research is distributed through multiple channels to help investors, advisors, researchanalysts, and asset managers make informed decisions, and our fundamental approach to researchand investing has produced exceptional results over time. Our proprietary Morningstar Wide MoatFocus IndexSM—which buys the 20 cheapest wide-moat stocks in our universe each quarter—hasoutperformed the S&P 500 by over 6% annually since its inception in 2002, as of June 2014.*Exhibit 2 Morningstar Approach to Equity ResearchFundamentalAnalysisMorningstar EconomicMoat Rating CompanyValuationFair ValueEstimateUncertaintyAssessmentStar RatingAnalyst conductscompany andindustry research:Analysts rate thestrength of competitiveadvantage, or moat:None, Narrow, or WideAnalyst considerspast financial resultsand focuses oncompetitive positionand future prospectsto forecast cash flows.Analyst uses adiscounted cash-flowmodel to developa Fair Value Estimate,which serves asthe foundation for theMorningstar Rating for stocks.The analyst thenevaluates the range ofpotential intrinsicvalues for the companyand assigns anuncertainty rating:Low, Medium,High, Very High,or Extreme.The current stock pricerelative to Morningstar’sFair Value Estimate,adjusted for uncertainty,determines theMorningstar Ratingfor stocks.Financial statementanalysisChannel checksAdvantages thatconfer a moat:Trade-show visitsHigh Switching Costs(Microsoft)Industry and companyreports and journalsCost advantage(Wal-Mart)Conference callsIntangible assets(Johnson & Johnson)Management andsite visitsNetwork Effect(Mastercard)Analyst entersassumptions intoMorningstar’sproprietary discountedcash-flow model.The uncertainty ratingdetermines the marginof safety required beforethe analyst recommendsthe stock. The higher theuncertainty, the widerthe margin of safety.Efficient Scale(Lockheed Martin) 2014 Morningstar. All rights reserved. The information, data, analyses, and opinions contained herein (1) are proprietary to Morningstar, Inc. and its affiliates (collectively, “Morningstar”), (2) may not be copied orredistributed, (3) do not constitute investment advice offered by Morningstar (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) are not warrantedto be accurate, complete, or timely. Morningstar shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.Past performance is no guarantee of future results. *Reflects correct performance statistics as of June 30, 2014.The Morningstar Ratingfor stocks is updatedeach evening after themarket closes.

Page 3 of 9Guide to Morningstar’s Equity Research Methodology3 Introduction to Morningstar RatingTM for Stocks3 We believe that a company’s intrinsic worth results from the future cash flows it can generate.3 The Morningstar Rating for stocks identifies stocks trading at a discount or premium to their intrinsicworth—or fair value estimate, in Morningstar terminology. Stocks rated as 5-star sell for thebiggest risk-adjusted discount to their fair values, whereas 1-star stocks trade at premiums to theirintrinsic worth.Four key components drive the Morningstar Rating for stocks:1. Our assessment of the firm’s economic moat2. Our estimate of the stock’s fair value3. Our uncertainty around that fair value estimate4. The current market priceThis process ultimately culminates in our star rating. Underlying this rating is a fundamentallyfocused methodology and a robust, standardized set of procedures and core valuation tools used byMorningstar’s equity analysts.The Morningstar Economic Moat RatingThe concept of an economic moat—a term Warren Buffett uses to describe the sustainability of acompany’s future economic profits—plays a vital role in our qualitative assessment of a firm’slong-term investment potential and in our fair value estimates. We assign one of three MorningstarEconomic Moat Ratings: none, narrow, or wide. There are two major requirements for firms to earneither a narrow or wide rating: 1. The prospect of earning above-average returns on capital; and 2.Some competitive edge that prevents these returns from quickly eroding. Exhibit 3 Morningstar Rating Calculation Adjusted for UncertaintyQ QQ QQQ QQQQ QQQQQPrice/Fair %90%125%85%1.251.0080%70%0.7560%LowMediumHigh 2014 Morningstar. All rights reserved. The information, data, analyses, and opinions contained herein (1) are proprietary to Morningstar, Inc. and its affiliates (collectively, “Morningstar”), (2) may not be copied orredistributed, (3) do not constitute investment advice offered by Morningstar (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) are not warrantedto be accurate, complete, or timely. Morningstar shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.Past performance is no guarantee of future results. *Reflects correct performance statistics as of June 30, 2014.50%Very High0.50

Page 4 of 9Guide to Morningstar’s Equity Research Methodology3 Determining Fair Value3 At the heart of our valuation system is a detailed projection of a company’s future cash flows,3 resulting from our analysts’ independent primary research. Analysts create custom industry andcompany assumptions to feed income statement, balance sheet, and capital investment assumptionsinto our standardized, proprietary Discounted Cash Flow modeling templates. By combining ouranalyst inputs with the moat rating, our models fade a firm’s Returns on Invested Capital andearnings growth rate from the end of an analyst’s explicit forecast horizon until the perpetuity period.The Uncertainty RatingMorningstar’s Uncertainty Rating captures the range of potential intrinsic values for a company anduses it to assign the margin of safety required before investing. The Uncertainty Rating representsthe analysts’ ability to bound the value of the shares in a company around the Fair Value Estimate,based on the characteristics of the underlying business. To formalize the process for quantifying theuncertainty in placing a value on a company, our framework breaks down the uncertainty aroundcompany value to four simplified conceptual elements: range of sales, operating leverage, financialleverage, and contingent events.Uncertainty Range of sales * operating leverage * financial leverage contingent event discountExhibit 4 Market ValuationGenerating the Star RatingOnce we determine the fair value of a stock, we compare it to the stock’s current market price on adaily basis, and the star rating is automatically re-calculated at the market close every day themarket is open. Our analysts keep close tabs on the companies they follow daily, and based onthorough and ongoing analysis, raise or lower their fair value estimates as warranted. It is also worthnoting that there are no predefined distributions of stars. That is, the percentage of stocks that earn5 stars can fluctuate daily, so the star ratings, in the aggregate, can serve as a gauge of the broader 2014 Morningstar. All rights reserved. The information, data, analyses, and opinions contained herein (1) are proprietary to Morningstar, Inc. and its affiliates (collectively, “Morningstar”), (2) may not be copied orredistributed, (3) do not constitute investment advice offered by Morningstar (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) are not warrantedto be accurate, complete, or timely. Morningstar shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.Past performance is no guarantee of future results. *Reflects correct performance statistics as of June 30, 2014.

Page 5 of 9Guide to Morningstar’s Equity Research Methodology3 market’s valuation. When there are many 5-star stocks, the stock market as a whole is more3 undervalued than when very few companies garner our highest rating.3Stewardship GradeThe Morningstar Stewardship Grade represents our assessment of management’s stewardshipof shareholder capital, with particular emphasis on capital allocation decisions. Analysts consider acompany’s investment strategy, history of investment timing and valuation, financial leverage,dividend and share buyback policies, execution, management compensation, related partytransactions, and accounting practices. Corporate governance practices, such as poison pills andstaggered boards, are only considered if they’ve had a demonstrated impact on shareholder value.Analysts assign one of three stewardship ratings: “exemplary,” “standard,” and “poor.” Analystsjudge stewardship from an equity holder’s perspective. Ratings are determined on an absolute basis.Companies are judged not against peers within their industry, but against ideal stewardship ofshareholder capital. Most companies will receive a standard rating, and this should be consideredthe default rating in the absence of evidence that a management team has made exceptionallystrong or poor capital allocation decisions. SMA history of value-accretive acquisitions, optimal financial leverage, ideal dividend and share buybackpolicies, and investments that enhance competitive advantages—these are the marks of exemplaryExhibit 5 Morningstar Equity Analyst Team StructureDirectorBasic MaterialsrDirectoryuFinancial Services and Real EstateDirectortsConsumer Defensive and CyclicalDirectorEnergyfDirectorUtilitiesoDirector ofCorporate ystsDirectoraiTechnology and Communication SerivcesStrategistsDirector of Economic Analysts Global Director ofEquity andCredit ResearchDirector of EquityResearchNorth AmericartyusdfopaiCredit AnalystsrtyusdfopaiAssociate DirectorsrtyusdfopaiSenior Analysts d DirectorHealthcareDirector of EquityResearchAsia-PacificDirector of Equity Operations 2014 Morningstar. All rights reserved. The information, data, analyses, and opinions contained herein (1) are proprietary to Morningstar, Inc. and its affiliates (collectively, “Morningstar”), (2) may not be copied orredistributed, (3) do not constitute investment advice offered by Morningstar (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) are not warrantedto be accurate, complete, or timely. Morningstar shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.Past performance is no guarantee of future results. *Reflects correct performance statistics as of June 30, 2014.rtyusdfopaiEquity Analysts

Page 6 of 9Guide to Morningstar’s Equity Research Methodology3 stewards of shareholder capital. Certain corporate practices, such as poison pills and staggered3 boards, are easily visible and garner much attention in governance analysis circles. Unfortunately,3 focusing on particular governance practices tends to poorly predict a firm’s ability to generateimproving returns on invested capital and shareholder returns. Fundamental investors should insteadconduct a more thorough analysis of management stewardship of shareholder capital.Morningstar Analyst TeamMorningstar’s team structure emphasizes deep bottom-up research while maintaining consistencyacross our coverage universe. Individual analysts focus on narrow industry segments and examinethe critical issues confronting the companies they cover. Senior analysts and team leaders surfacethemes and guide the research, also coordinating macro inputs across industries (e.g. same oil priceassumptions in energy team’s models), and associate directors provide a sector overview. The teamemphasizes surfacing ideas and uncovering opportunities that represent value not yet recognized bythe market.Morningstar Equity Analyst ReportMorningstar’s Equity Analyst Report delivers Morningstar’s holistic view on a stock. It conveysMorningstar’s qualitative and quantitative ratings on the stock, as well as written research from theMorningstar analyst who covers it. Analyst reports on over 1,400 stocks demonstrate a stock’svaluation and what investment considerations should be. 2014 Morningstar. All rights reserved. The information, data, analyses, and opinions contained herein (1) are proprietary to Morningstar, Inc. and its affiliates (collectively, “Morningstar”), (2) may not be copied orredistributed, (3) do not constitute investment advice offered by Morningstar (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) are not warrantedto be accurate, complete, or timely. Morningstar shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.Past performance is no guarantee of future results. *Reflects correct performance statistics as of June 30, 2014.

Page 7 of 9Guide to Morningstar’s Equity Research MethodologyMorningstar EquityAnalyst Report Features33The Morningstar Rating for stocks is calculated3 bycomparing a stock’s current market price with Morningstar’sfair value estimate of the stock, culminating in ourstar rating. Ratings are updated daily and can thereforechange daily.The “Fair Value Estimate” is a Morningstar analyst’sestimate of what a stock is worth, calculated by determininghow much we would pay today for all the streams of excesscash generated by the company in the future. We arriveat this value by forecasting a company’s future financial performance using a detailed discounted cash-flow model.This differs from the “Quantitative Fair Value Estimate,” whichquantitatively calculates the fair value, based on theanalyst-driven ratings of comparable companies. Empirically,we find quantitative ratings and analyst-driven ratings tobe equally powerful predictors of future performance. Whenthe analyst driven rating and the quantitative rating agree,we find the ratings to be much more predictive than when theydiffer. In this way, they provide an excellent second opinionfor each other. When the ratings differ, it may be wise to followthe analyst’s rating for a truly unique company with itsown special situation, and follow the quantitative rating whena company has several reasonable comparable companiesand relevant information is flowing at a rapid pace.The “Price/Fair Value” ratio is calculated by dividing thelast price by the “Fair Value Estimate.” It indicates whethera stock is currently overvalued, undervalued, or fairly valued,according to the fair value estimate. A price/fair valueratio of less than 1 indicates the stock is undervalued, whilea price/fair value ratio of more than 1 indicates a stockis overvalued.Our corporate “Stewardship” rating represents ourassessment of management’s stewardship of shareholdercapital, with particular emphasis on capital allocationdecisions. Analysts assign one of three stewardship ratings:exemplary, standard, or poor. Most companies will receivea standard rating, and this should be considered thedefault rating in the absence of evidence that a managementteam has made exceptionally strong or poor capitalallocation decisions.The Morningstar Economic Moat Rating refers to howlikely a company is to keep competitors at bay for anextended period. We classify companies as No-Moat,Narrow-Moat, and Wide-Moat.The “Uncertainty Rating” describes our level ofuncertainty about the accuracy of our fair value estimate.The lower the uncertainty, the narrower the potential rangeof outcomes for that particular company. The rating isexpressed as low, medium, high, very high, or extreme.Morningstar Equity Analyst Report Report as of 29 Jul 2014 Page 1 of 12Apple Inc AAPL (XNAS)Morningstar RatingQQQ29 Jul 2014Last PriceFair Value EstimatePrice/Fair Value98.38 USD87.00 USD1.1329 Jul 2014Morningstar PillarsAnalystQuantitativeEconomic MoatValuationUncertaintyFinancial urce: Morningstar Equity ResearchQuantitative ValuationAAPLUSAaUndervaluedPrice/Intrinsic ValuePrice/EarningsForward P/EPrice/Cash FlowPrice/Free Cash FlowDividend Yield %Fairly ValuedOvervaluedCurrent5-Yr ector 81.97Dividend Yield %Market Cap (Bil)IndustryStewardship1.79589.09Consumer ElectronicsStandard29 Jul 201429 Jul 2014Apple is driving software and services innovation to capture premiumpricing on hardware.Brian Colello, CPA, 22 July 2014Analyst NoteInvestment ThesisApple reported solid third-quarter earnings, and gaveinvestors a fourth-quarter outlook that was relatively inline with our expectations. However, the bigger storycontinues to revolve around buzz for the company’supcoming products (iPhone 6, new iPads, and a possibleiWatch). Management has set a bullish tone for its productpipeline and for revenue growth this holiday season. Weexpect to maintain our 87 fair value estimate, and Apple'snarrow economic moat rating.We believe Apple's strength lies in its experience andexpertise in integrating hardware, software, services, andthird-party applications into differentiated devices thatallow Apple to capture a premium on hardware sales.Although Apple has a sterling brand, strong productpipeline, and ample opportunity to gain share in its variousend markets, short product life cycles and intensecompetition will prevent the firm from resting on

Guide to Morningstar’s Equity Research Methodology Morningstar Equity Research Overview Morningstar is a leading provider of independent investment research currently serving clients globally through our presence in N

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