What is the Morningstar Star Rating for Stocks?

VIDEO: What determines a stock's Morningstar star rating? Analyst Alex Morozov explains

Holly Black 26 February, 2020 | 11:29AM
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Holly Black: Welcome to Morningstar's "Ask the Expert." I'm Holly Black. With me is Alex Morozov. He is head of European Equity Research at Morningstar. Hello.

Alex Morozov: Hi, Holly.

Black: So, whenever I open up a Morningstar analyst report on a stock, I see stars, the Morningstar Star Rating. What does that tell me?

Morozov: Well, the Star Rating, especially for users of Morningstar research, especially funds research, when they see Star Rating, they immediately assume, well, that's the Morningstar funds analysts' opinion of funds' prior performance. For stock rating, stars are actually an indicator of what our analysts think in terms of how attractive the stock as an investment right now. So, think of the Star Ratings as equivalent of some of those traditional research providers' buy/sell rating. So, ranging from a 5-Star being the most undervalued stocks to 1-Stars being the stocks that are materially overvalued relative to our fair value estimate.

Black: So, this is all centred about where the shares are trading today versus the fair value estimate, which is what you think they're worth.

Morozov: Right. That's exactly what it is. Maybe a little element, a little wrinkle in that is there is also the, what we call, an uncertainty rating. So, something that's more commonly known as maybe a risk rating of a business – how likely are those earnings to be very volatile over the next 5 to 10 years or free cash flows in our case. So, think of a Star Rating as taking the intrinsic value, what we think that the company is worth the fair value estimate compared to stock price and then adjusted for this risk rating of a business. And that's how you arrive at ultimately those Star Ratings.

So, if you're an investor and you open a Morningstar company report, and you say, well, Morningstar thinks it's a 5-Star stuck, what should I do then? Well, that most likely means that given the uncertainty of this business, uncertainty profile of this business, Morningstar thinks that it's one of the most attractive investment opportunities right now. On the flip side, you take a 1-Star stock, for example, Tesla…

Black: You might be overpaying.

Morozov: Yeah, you might be overpaying materially. I mean, Tesla is no doubt in the news right now and the stock price is very, very, very lofty. But 1-Star indicates that our analysts think it's very overvalued.

Black: So, what does it take for a Star Rating to move? Will something ever go from a 5 to 1 or is it a lot more gradual?

Morozov: Right. Well, there are a couple of factors that could result in a Star Rating changing, let's say, from 5-Stars to 4-Stars. One, if our analysts actually changed the fair value estimate – and there are a couple reasons why the analysts might change their fair value estimate. For example, if they think that the company is performing better than they expected or worse than expected. Maybe the analysts decide to change the moat rating of a company. So, economic moat rating pertains to our assessment of the competitive advantage of the business. And let's say that there's some industry developments, some massive disruptions that our analysts say, you know what, the economic moat rating, or competitive advantage is not as strong as we previously thought it was. And since the economic moat rating actually specifically and implicitly flows into our fair value estimates, that could also result in a change the fair value estimate. So. that's one reason.

The second reason and that's the reason that probably is more common is that the stock price actually moves. So, what our analysts try to tell investor is that this particular company is worth X, and the wider the discount, the greater the Star Rating. So, when the stock price starts moving towards our fair value estimate, which is great if you're an investor, the Star Rating starts to shrink. So, it goes from 5-Stars to perhaps 3-Stars over time and maybe even 1-Star if it wildly overshoots our fair value estimate. So, if you're an investor, you really do want to see that development, assuming that's for the reasons that the stock is appreciating rather than the fair value estimate is getting cut.

Black: And what about 3-Star rating, right in the middle? So, it's quite clear what 1 and 5 would tell me as an investor, but what does 3 tell me?

Morozov: Well, the way our Star Rating works is that we say that a 3-Star stock is, I would say, considered to be fairly valued. We're not saying that an investor should not look at those securities. What we are saying, however, is that the stock is probably going to return somewhere in line with what the market should return over time. So, a 3-Star stock could still be a good investment depending on your required returns, but I wouldn't consider it to be a very attractively priced. So, maybe an equivalent to a hold, if you will.

Black: Well, thank you so much for your time.

Morozov: Yeah, my pleasure.

Black: And thanks for joining us.

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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Holly Black  is Senior Editor, Morningstar.co.uk