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Stock Strategist

Morningstar Rating for Stocks: Changes to Uncertainty Bands

We're fine-tuning the way we assign star ratings to stocks.

Effective Friday, December 10, we will implement a slight change to the uncertainty bands across our coverage universe. We use these uncertainty bands to determine the star rating that each stock should receive.

For any given company, we consider our estimate of its fair, or intrinsic, value to be a single point within a range of possible fair values. To help us get a handle on that range, we perform scenario analysis on individual companies, stress-testing our valuation models under a variety of assumptions. We then assign that company an Uncertainty Rating based on this assessment. For low-uncertainty stocks, we believe the distribution of fair values is fairly tight, and we therefore demand a relatively small margin of safety before we recommend purchase of the shares. For high-uncertainty stocks, on the other hand, we demand a steep discount to our fair value estimate before we assign it a 5-star rating.

Back in 2008, we widened the bands to reflect the heightened market volatility. By increasing the margin of safety, we were able to increase the quality of companies landing on our 5-star list. Even so, we had more than 600 stocks rated 5-stars during the market meltdown--a level we thought appropriate given how cheap stocks had become.

Fast-forward to late 2010, and the market is much more fairly valued, in our opinion. The median stock in our universe trades right at a price/fair value (P/FV) ratio of 1.0. The number of 5-star stocks hovers around 40, or less than 3% of our coverage universe. In addition, as a result of the financial crisis, we raised the Uncertainty ratings on many stocks, particularly those shown to be dependent on capital markets to sustain their businesses. Given these adjustments at the stock level, we feel now is an appropriate time to adjust our overall high- and very high-uncertainty bands, to bring them more into line with the other bands.

As you can see from the following illustration, the discounts to fair value needed for a 5-star rating now increase steadily as you move from lower to higher uncertainty. The 5-star cut-off is 80% of fair value for low-uncertainty stocks, 70% for Medium, 60% for High, and 50% for Very High. Prior to the change, we required a high-uncertainty stock to trade at 50% of its estimated fair value before awarding it 5 stars, and a very high-uncertainty stock to trade at 40% of fair value.

The result of the most recent change will be a somewhat lower hurdle for stocks to hit 5-stars or 1-star in the high- and very high-uncertainty bands. Practically speaking, the change will mean slightly more 5-star and 1-star stocks than we would have had otherwise. We don't expect to change our uncertainty cut-offs frequently, but we will periodically revisit them, and make adjustments accordingly.