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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Glaser: If these estimates are moving then, how do you interpret that in terms of making a buy or sell decision, if you know that there is a good chance that the estimate could change materially within a year?
Coffina: I think there are few factors there. One is that we normally try to invest with a margin of safety, so we only buy a stock if we think it’s trading at a meaningful discount to fair value. The greater the uncertainty underlying our fair value estimates, which is reflected in our uncertainty ratings, the greater the margin of safety we require. So a very hard-to-value business, maybe a small-cap tech company or a biotech or something like that we would require a larger margin of safety than a relatively steady, predictable business like Johnson & Johnson or PepsiCo, something like that.
First thing is, invest with a margin of safety. The second thing is to focus on uncertainty. The lower the uncertainty, the greater the confidence we can have in our fair value estimates. This has been borne out over time, where our Morningstar fair value estimates tend to perform much better for larger, more stable, wide-moat companies with lower uncertainty than they perform for companies without an economic moat or very high uncertainty.
Then the other thing to keep in mind is that fair value itself is a moving target. It’s not the end of the world, I think, to continue to hold a company trading at fair value or even at a slight premium to fair value. Assuming you bought it with a margin of safety and the stock has since appreciated because, again, those fair value estimates should go up over time. If we’re right about our cash flow forecast and a company like PepsiCo is trading right around fair value, that still implies that investors could expect a total return somewhere in the neighborhood of 8% a year, which would be in line with our cost of equity assumption.
Glaser: We’ve talked about those examples where fair value estimates are changing because of that time value of money. But how about when they change because the cash flow forecast was wrong, or analysts have changed what they think the company is going to do in the future? How should investors interpret that in terms of a buy-sell decision?
Coffina: There’s no denying that there is lot of uncertainty in the business world, and there is nothing we can do about that. It’s really why stock investors or investors in common stocks have been rewarded so handsomely over long stretches of time because you’re taking on a lot of uncertainty when you invest in a common stock. There is all sorts of things that could happen, whether it’s changes in commodity prices, shifts in consumer preferences, changes in government regulations, whatever it might be, things will happen that we can’t predict and we can’t hope to predict ahead of time.
Again, I think the key is focusing on a margin of safety and focusing on those situations where we do have an edge in predicting the future value of the business. For example, in StockInvestor’s portfolios, I try to avoid investment stories where our primary investment case is based on a commodity price forecast. Our analysts do their absolute best to predict future commodity prices, but it’s just an inherently difficult thing to do, very hard to gain an edge over oil and natural gas prices or whatever it might be, is going to be five or 10 years in the future.
On the other hand, there are situations like Coca-Cola, where it’s much easier to predict that Coke’s volumes are going to go up zero to 4% a year; prices are probably going to go up zero to 4% a year, and we can have a fairly high degree of certainty in forecasting what Coke’s revenue is going to be five years from now as compared to a company like Exelon, which we also own in StockInvestor’s Tortoise portfolio. In that case it’s really based on what future electricity prices are going to be. Those in turn are determined by future natural gas prices, and again, we do our best to forecast future natural gas prices, but it’s something that’s just very hard to get an edge on. So I would prefer, given a similar margin of safety, a Coca-Cola to an Exelon.
As it happens right now, Exelon is trading at a pretty deep discount to fair value, so you could say that the risk/reward is in your favor. But again, it’s very much going to depend on those future commodity prices.
Glaser: Underlying uncertainty in the business is going to create underlying uncertainty in the fair value estimate?
Coffina: Exactly, and there’s no getting around that. We just need a larger margin of safety when dealing with higher-uncertainty company. I think investors need to be aware of their own risk tolerance, and also understand that investing is a probabilistic exercise. So we’re not going to be right 100% of the time and that’s not even really our goal. Our goal is just to have the winners outweigh the losers, which means that we need to make the odds in our favor.
If the weatherman predicts that it’s going to rain with a 30% chance and it rains, that doesn’t mean that the weatherman was right or wrong. You need to do it 100 or 200 times and see what happens before you can say whether that 30% chance of rain prediction was correct. Really it’s a similar situation in investing, where you just want to place your bets where the odds are on your side and then hopefully over time that will show up in more winners than losers.
Glaser: Matt, thanks so much for joining me today.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I’m Jeremy Glaser.
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