5-Stars with More Certainty
The future for these stable firms is easier to forecast--and looks bright for shareholders.
At Morningstar, we spend a lot of time thinking about the range of possible outcomes for the companies we cover, even though the fair values we publish are point estimates. One of the key steps in our approach to stock investing is determining the "fair value uncertainty" for each company. Fair value uncertainty is meant to give investors an idea of how tightly we feel we can bound our fair value estimate for any given firm.
To measure fair value uncertainty, analysts consider sales predictability, operating leverage, financial leverage, and exposure to contingent events. Based on these factors, they classify the stock into one of several uncertainty levels: low, medium, high, very high, or extreme. The greater the level of uncertainty, the greater the discount to fair value required before a stock can earn 5 stars, and the greater the premium to fair value must be before a stock earns a 1-star rating.
The diagram below illustrates the premium/discount to fair value necessary for each uncertainty level to earn a particular star rating. As you can see, there is a big difference in the discount required to earn 5 stars on a company with a low uncertainty rating versus a company with a very high uncertainty rating. A company with low uncertainty only has to be priced below 80% of its fair value to earn 5 stars, while a company with a very high uncertainty rating would need to be under 40% of its fair value. In simple terms, when there is more risk associated with a company, we build in an extra cushion to help hedge against unpredictability.
Rachel Haig does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.