Stocks: What's Behind the Morningstar Ratings?

There's more to the Morningstar Rating systems for funds, ETFs, and stocks than how many stars you see

Esther Pak 13 July, 2011 | 10:49AM
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Finding the right investments can be a daunting process. To help alleviate the burden of choice overload, Morningstar has created an array of tools to help investors assess an investment's key characteristics at a glance.

The Morningstar Style Box for funds (OEICs/Unit Trusts), for example, helps you quickly see how a fund actually invests the bulk of its assets. Meanwhile, the Morningstar Rating for funds, introduced in 1985, helps investors quickly gauge how a fund has balanced risk and reward. We've since introduced star ratings for individual stocks and exchange-traded funds, and we're working on extending this service to include closed-end funds.

There are some important distinctions between these ratings, and it's important to bear them in mind if you're using these ratings as part of your security-selection process. To help shed light on the key similarities and differences, we'll provide a brief overview of what the star ratings indicate for each investment type, how they're calculated, and how to (and how not to) use them.

Star Rating for Stocks
Snapshot
Whereas the fund and ETF star ratings are both backward-looking quantitative measures of a fund's risk/reward profile, the stock star rating is completely different. It's both quantitative and qualitative, for starters, and it's meant to be forward-looking. If a stock has a high star rating, that means we think the shares have good upside potential and that prospective investors might want to keep them on their radar.

How It's Calculated
The Morningstar Rating for stocks is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value. Morningstar analysts arrive at fair value estimates for their companies by estimating a company's future financial performance using a detailed discounted cash flow model that factors in projections for, among other things, the company's sales, profitability and financing. Morningstar's analysts also consider the competitive advantages and staying power of the businesses (that is, their economic moats) when projecting these figures.

Generally speaking, stocks trading at large discounts to our analysts' fair value estimates will receive higher (4 or 5) star ratings, and stocks trading at large premiums to their fair value estimates will receive lower (1 or 2) star ratings. Stocks that are trading very close to our analysts' fair value estimates will receive 3-star ratings. Stock star ratings are recalculated daily, to reflect changes in share price relative to our analysts' estimates of their fair value, but they won't necessarily change on a daily basis.

The higher a company's risk, the cheaper its stock has to be to earn a 5-star rating. For example, in order for a firm with below-average business risk to receive 5 stars, it needs to be just 15% below analysts' fair-value estimate, while an above-average-risk stock would require a 35% discount to reach 5-star status.

Unlike funds and ETFs, where there's a fixed distribution of high and low star ratings within each peer group, it's highly possible that a given stock sector will consist entirely of high- or low-rated companies. Furthermore, there is no predefined distribution of stars in determining a stock's star rating--thus, for example, the number of stocks earning 5 stars can fluctuate daily.

How to Use It (and How Not to)
In contrast with the fund and ETF star ratings, which measure only risk and reward, the stock star rating is more holistic and forward-looking.

When choosing specific stocks, investors can turn to the Equity Quickrank to quickly rank by certain criteria.

Keep in mind that not every 5-star stock will be right for every investor; risk tolerance should also play a role. Moreover, investors should bear in mind their own situations, including the tax and transaction costs, before dumping 1-star stocks.

Although the stock star rating helps expose undervalued stocks and flags those that are pricey, you'll need to check out the stock's Analyst Report to see if you agree with the reasoning behind the star rating. Then, you can evaluate whether the stock makes sense in your portfolio given your risk tolerance and other companies you already own.

Stock analyst reports are a feature of Morningstar.co.uk's Premium service. Find out more here.

Click here to read about Morningstar's Analyst Ratings for Funds.

Click here to read about Morningstar's Analyst Ratings for Investment Trusts.

Click here to read about Morningstar's Star Rating for Funds.

Click here to read about Morningstar's Star Rating for Investment Trusts.

Click here to read about Morningstar's Star Rating for ETFs.

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

Esther Pak  is an assistant site editor of Morningstar.com.