How to Use Morningstar Ratings to Find Quality Stocks

THE VALUE INVESTOR: A guide to understanding Morningstar analyst-driven stock ratings and how they work together

Karen Wallace 20 August, 2015 | 5:06PM
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To fully understand the star rating and how you might use it as a consider-buying gauge, it might help to get a brief background on how a few analyst-driven Morningstar ratings are determined and how they work together.

The Star Rating

Let's start with the star rating, whose official name is the Morningstar Rating for stocks. This is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value. The bigger the discount, the higher the star rating.

Our rating system also factors in an uncertainty adjustment, known as the fair value uncertainty rating, so that it's more difficult for a company to earn a 5-star rating the less confident we are in the precision of our fair value estimate.

Fair Value Uncertainty

When Morningstar equity analysts assign a fair value estimate to a stock, it's a single value estimate. But in actuality, our analysts predict of a range of outcomes or scenarios for each company when determining its fair value estimate. Our uncertainty rating follows the principals of a confidence interval, surrounding our fair value estimate.

Essentially, a low fair value uncertainty rating means that the analyst thinks he or she can more tightly bound the fair value of a company because he or she can estimate its future cash flows with a greater degree of confidence. In determining this rating, our analysts score companies based on sales predictability, operating leverage, financial leverage, and exposure to contingent events, for example, a biotech company's success or failure may hinge on whether a single drug is approved or not.

Note: This rating is sometimes referred to in shorthand as the "uncertainty rating," which may lead some people to assume the measure is intended to predict the future volatility of the stock's price. Although that is not the intent of the rating, some of the elements that go into determining the fair value uncertainty rating, such as leverage and risk of events such as litigation, could arguably result in a more volatile stock price.

Economic Moat

The idea of an economic moat – a term originally coined by Warren Buffett – refers to how likely a company is to keep competitors at bay for an extended period. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors, and it's this characteristic – think of it as the strength and sustainability of a firm's competitive advantage – that Morningstar is trying to capture with the economic moat rating.

A company that has generated capital higher than its cost of capital for many years probably has a moat, especially if its returns on capital have been rising or are fairly stable. Here are some things that can give companies economic moats:

Network effect: Lots of people are using the service. That, in turn, makes the service more valuable to the people who use it. For some illustrations of companies that have network effects.

Intangible assets: Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company's products, or allow the company to charge a significant price premium.

Cost advantage: Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins.

Switching costs: When it would be too expensive or troublesome to stop using a company's products, the company often has pricing power.

Efficient scale: When a niche market is effectively served by one or a small handful of companies, efficient scale may be present

Putting It All Together

The proprietary Morningstar ratings mentioned above can help you narrow your focus to find high-quality stocks that have a good chance of outperforming peers. In addition, the more comprehensive Stock Analyst Reports can provide valuable research that can help you make your investment decision.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Karen Wallace  Karen Wallace is an editor with Morningstar.