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Introducing Changes to Morningstar's Equity Valuation Methodology

We've enhanced our methodology, which could result in modest fair value changes.

Matthew Coffina, CFA, 05/17/2012

At Morningstar, we assign fair value estimates to around 1,800 companies across the globe. Each of these fair value estimates is based on a rigorous discounted cash flow (DCF) model built by one of our analysts using a standard Morningstar template. Occasionally, we find ways to improve our methodology. Over the next several months, we will be rolling out the sixth generation of our internal DCF template. In this article, we describe some of the key features of our updated valuation methodology.

Changes to our methodology may require adjustments to some of our fair value estimates, which you may notice in the coming months as analysts transition their companies to the new model. Some of these changes will tend to increase our fair value estimates, while others will cause our fair value estimates to decline.

Morningstar's Three-Stage Discounted Cash Flow Valuation
Our DCF model includes three stages of analysis. The first stage includes our forecasts for the next five to 10 years. In the first stage, analysts make explicit forecasts for all of a company's important financial statement items, such as revenue, operating costs, capital expenditures, and investments in working capital.

In the second stage, analysts are more limited. We take earnings from the last year of Stage I and assume that they grow at a constant rate. We determine the investment needed to achieve this growth by assuming a constant return on new investment. Analysts are responsible for choosing the growth rate, the rate of return on new investment, and the length of Stage II, but otherwise don't need to make explicit forecasts for individual financial statement lines.

Stage II assumptions are the primary vehicle for incorporating our analysis of economic moats in our fair value estimates. Companies with wide and narrow moats are expected to earn returns on new invested capital that exceed their cost of capital in Stage II. The wider the moat, the longer Stage II is likely to last. In general, we assume narrow-moat companies can earn excess returns on capital for at least 15 years, while wide-moat companies can earn excess returns on capital for at least 20 years.

Our model concludes with a third stage. In Stage III, all companies are assumed to be the same. Return on new invested capital is set equal to the weighted average cost of capital; every moat is eventually eroded--no company can earn excess returns forever. We also assume returns on existing invested capital remain constant in Stage III.

Our latest model includes several alternative Stage II-III methodologies, as well. These include terminal multiples (such as EV/Sales and EV/EBITDA) and the ability to enter the total value of cash flows beyond Stage I directly. These alternative approaches should only be used in special circumstances where the standard three-stage method would be inappropriate.

A change to our formulas for valuing Stage II and Stage III cash flows will have the largest downward effect on our fair value estimates, particularly for companies where a significant portion of value is concentrated in these later periods. This is because of more conservative assumptions for long-run reinvestment needs relative to previous versions of our model.

Matthew Coffina is a stock analyst at Morningstar.
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