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By Jeremy Glaser and Matthew Coffina, CFA | 04-22-2013 12:00 PM

How Morningstar Values Stocks

StockInvestor editor Matt Coffina breaks down how cash flow analyses, uncertainty ratings, and economic moats play key roles in our equity valuation methodology.

Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. We've had some questions about how Morningstar's equity analysts come up with the fair value estimates for the stocks that they cover. Here to fill us in on the process is Morningstar's Matt Coffina. He is the editor of StockInvestor, and he previously was the valuation model developer.

Matt, thanks for joining me today.

Matthew Coffina: Thanks for having me, Jeremy.

Glaser: Let's start at the beginning. What kind of model do our analysts use to come up with the fair value estimate or what they think that an individual stock is worth?

Coffina: We use what's called the discounted cash flow model. The basic idea is we're thinking of a company as an owner of that company would. We're taking our best estimate of the future free cash flows that the company is generating. So, free cash flow is basically the cash that's left over to provide a return to investors--creditors, debtholders, and equityholders--after you pay all the operating costs, capital expenditures, investments on working capital, and so on that a company needs to run its business and grow its business.

The cash flow that's left at the end, we're assuming that belongs to shareholders. And then what we're doing is adding up all of the future years' cash flows, except, while we're doing this, we're discounting those cash flows back to the present using a discount rate. The reason you have to discount the cash flows is that cash in the future is worth less than cash that you have in your pocket today. The reason is pretty straightforward. If I have the cash today, I could invest it and earn interest or earn some investment returns, and also there is some possibility that that future cash flow will never be realized and so I need to be compensated for that risk.

Glaser: Discounted cash flow models obviously aren't the only way to value stocks. Why do you think it's a superior one to, say, using a P/E multiple?

Coffina: The advantage of discounted cash flow analysis is that it really allows you to incorporate any number of different circumstances or special situations. For example, if you wanted to use a P/E multiple but the company has a loss this year, well, how do you handle that situation? Or, if the company is growing very quickly in the short term, what's an appropriate P/E multiple in that circumstance? It can be very hard to tell. And often the choice of a P/E multiple would be arbitrary based on where the company has traded historically, where comparable companies are trading, but it's not necessarily grounded in the future growth and cash flows of that company.

So, DCF we think is the most flexible approach. It allows you to account for special circumstances, allows you to incorporate multiple years of free cash flows. So, we're making usually explicit forecasts for at least five years on every individual financial statement line item; revenue, costs, and so on. And then also an important part of this is that it really lets you get at the drivers of valuation. It helps you understand what's really important to the value of that company, where there is room for the company to be worth more or less than your base-case scenario depending on revenue or margins or whatever it is that's particularly important for that company that you are looking at.

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