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By Matthew Coffina, CFA and Jeremy Glaser | 10-29-2013 02:00 PM

How to Interpret Valuation When Buying and Selling Stocks

Morningstar analysts weigh many factors in their equity fair value estimates, and individuals should focus on uncertainty and margin of safety before making a trade, says StockInvestor editor Matt Coffina.

Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. What’s the best way to interpret our stock fair value estimates? I’m joined today by Matt Coffina--he’s the editor of Morningstar StockInvestor--to take a look.

Matt, thanks for joining me today.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Before we dive in, can you give us a little bit of an overview of how fair value estimates are calculated by Morningstar analysts, a little bit about what that process is?

Coffina: Sure. Very briefly, our analysts use what’s called discounted cash flow analysis, and the idea is that a company’s value today is based on its ability to generate free cash flows into the future. Free cash flows would be all the cash that’s available to shareholders after all other obligations are paid. Things like operating costs, investments in working capital, investments in capital expenditures, after all those cash outflows, what’s left for shareholders? That free cash flow could either be paid out to shareholders directly as dividends or might be retained by the company, reinvested in acquisitions or future growth projects, or whatever it is, or even let the cash accumulate on the balance sheet. We think, over time, shareholders will benefit from that one way or another.

Now, the future free cash flows also have to be discounted back to the present, because cash five and 10 years from now is not worth as much as cash in your pocket today. If you have the cash in your pocket today, you could either invest it and earn a return, plus it’s also more certain that you’ll have it if you actually have it on hand versus the cash flows that a company is going to generate in the future are subject to all sorts of uncertainties in a business environment.

Glaser: These fair value estimates aren’t static, though. They do change over time. What precipitates those changes? When do analysts decide that it’s time for an update or that it’s necessary to update the fair value estimate?

Coffina: There are two big sources of changes to fair value estimates. The first would be that our fair value estimates naturally tend to increase over time with what’s called the time value of money. As time marches on, you’re discounting each year’s future free cash flows by one year less for every year that passes, and the company is receiving cash flows, it’s piling up on the balance sheet, being paid out as dividends, or whatever it is. A company’s fair value tends to increase over time to the extent that those cash flows are retained. Dividends are just received directly, but cash flow that’s retained, we expect to add to the intrinsic value of a company.

All else equal, you would expect a fair value estimate to increase by the cost of equity every year. This is an assumption that our analysts are using in their models. It’s basically the discount rate for the free cash flows to equity holders less the dividend yield. If a stock has a 10% cost of equity according to our analysts and it pays a 2% dividend yield, then you would expect the fair value estimate to go up by about 8% a year, again, holding all else equal.

The key caveat to that is that all else is almost never equal. Our analysts are making cash flow forecasts many years into the future, which is based on their views of revenue, which depends on volumes, prices for the product, and so on. It depends on their assumptions about operating costs and operating margins, their view of capital expenditures and other investments in the business, and all of these assumptions are subject to change, and in fact, are constantly changing as new information is received. So I think it’s only healthy that our fair value estimates would change regularly, and we try to look at our models at least once a quarter or whenever new news breaks to incorporate new information as it becomes available.

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