Why Do Stocks' Fair Value Estimates Change?

Question: Why and when does Morningstar change fair value estimates for stocks?

Answer: There are many reasons Morningstar equity analysts might make a change to our fair value estimates. Many times the change is not a large, wholesale change; it's often the result a small tweak to our model based or a time value of money update, or an increase or decrease in the underlying inputs in our model based on new information revealed in quarterly earnings reports.

But other times we do make material changes to our fair value estimates when new information becomes available that causes us to re-evaluate our near-term or long-term thesis.

I examined some recent fair value estimate changes and pulled out some for illustration. While this list is by no means exhaustive, the following are common reasons we might make a change to a company's fair value.

Time Value of Money Some readers may wonder why our fair value estimate for a stock ticks up a bit from year to year, even when our forecast for the company isn't changing. When you see a company's fair value estimate has moved upward steadily in small increments over the years, many times it is due to an adjustment for the time value of money.

Morningstar's philosophy of stock investing is that a firm's intrinsic worth, or fair value estimate, is equal to the value of the cash the business can generate in the future. But the cash that is generated today is worth more to investors than the cash could be generated in the future due to the uncertainty that the business will actually deliver those results. And if you give up a dollar today to buy that future cash flow, you have the opportunity costs of using that dollar to invest in other, potentially safer assets.

For this reason, we apply a discount rate to those future cash flows to account for these unknowns. More on how we arrive at our discount rate can be found here, but the key driver for most firms is the cost of equity, or what return shareholders demand on an average, annualized basis (not adjusted for inflation) to hold the shares. Unlike a bond yield, the cost of equity can't be observed directly; however, we have a process to estimate it based on a number of factors that look to capture the risk characteristics of various businesses. In short, the riskier the company, the higher the cost of equity should be.

Why does this lead, all else equal, to fair value estimate going up every year by the cost of equity (net of the shareholder return allocated to dividends)? Essentially, at the end of the year all of those cash flows that the analyst had predicted have now actually been realized by the business and no longer need to be discounted as the uncertainty is gone and the cash is now in hand. (Note dividends need to be excluded here because those are payout that are in the hands of shareholders of the time of the payment and are no longer available to the company).

In other words, holding the fair value estimate steady over a multiyear time period would imply that a company's cash flows have been coming in below our expectations.

For example, take a look at this price/fair value chart for

.) As the firm has mostly met our expectations, the increases have been driven by these time value of money expectations.

Increased Optimism Sometimes the information in a quarterly earnings release causes us to re-evaluate our forecast for a company's near- or long-term prospects. As we incorporate more-optimistic assumptions into our model, it could result in an upward revision to our fair value estimate.

For instance,

In addition, equity analyst Abhinav Davuluri recently raised

Decreased Optimism Of course, the opposite of that is also true. Sometimes we lower a company's fair value estimate to incorporate our more pessimistic outlook.

"Given Bristol now trails

Also,

"While the firm's growing user engagement is reaffirming part of our thesis, lower-than-expected user growth and delay in more effective monetization of the users are concerning," said equity analyst Ali Mogharabi. He noted that management did not provide full-year 2017 revenue guidance, but the first-quarter adjusted EBITDA guidance and implied revenue range were well below our forecast. Mogharabi lowered Twitter's fair value estimate to $18 from $20 given questions surrounding the company's ability to grow its user base.

Currency

We sometimes make changes to a company's fair value as a result of currency adjustments. For instance, we recently raised our fair value estimate for

Buyouts When companies are being acquired, we often update our fair value estimate to the takeout price.

For instance, we recently updated our fair value estimate for

Similarly, we raised our fair value estimate for

Political and Economic Forecasts We also include the probability of certain macroeconomic and political events; these forecasts can also impact a company's fair value estimate.

For instance, we recently updated our fair value estimates for

). Equity sector director Daniel Rohr also notes that it is likely that the Trump administration will impose a stiff tariff on Canadian softwood lumber (discussed

). As a result, we increased our fair value estimate for each company by $1--Rayonier went to $27 from $26, and Weyerhaeuser went from $35 from $34.