Why Do Stocks' Fair Value Estimates Change?
We explain some of the main reasons Morningstar equity analysts may adjust their assessment of a stock's intrinsic value.
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 Costco (COST). (Premium Members can see this type of chart for any security by clicking on the Price vs. Fair Value tab on the stock's quote page on beta.morningstar.com.) As the firm has mostly met our expectations, the increases have been driven by these time value of money expectations.
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, Apple (AAPL) reported strong fiscal first-quarter results on Jan. 31, setting quarterly records in both iPhone unit sales and iPhone average selling prices during the all-important holiday season, boosted by a mix shift toward the higher-priced iPhone 7 Plus, said equity director Brian Colello. He recently raised Apple's fair value estimate to $138 per share from $133 owing to his more optimistic near-term revenue and long-term operating margin assumptions for the company.
In addition, equity analyst Abhinav Davuluri recently raised Advanced Micro Devices' (AMD) fair value estimate to $6 from $4 after the firm reported encouraging fourth-quarter results. He said the quarterly results revealed "solid progress in the firm's recovery over the course of 2016"; he believes the company is poised to make further advances back to profitability in 2017 as it has numerous products in its pipeline set to be released in upcoming quarters. The fair value increase is the result of Davuluri's more optimistic growth assumptions, as he now expects the firm to achieve a top-line compound annual growth rate in the high single digits through 2021.
Of course, the opposite of that is also true. Sometimes we lower a company's fair value estimate to incorporate our more pessimistic outlook.
Bristol-Myers Squibb (BMY) is a recent example. Equity sector strategist Damien Conover recently lowered his fair value estimate for Bristol-Myers to $64 from $68 because of a less optimistic outlook for the company's Opdivo drug. Conover wrote in a recent analyst report that although Bristol remains on solid footing for long-term growth, management suggested "less confidence in the combination of Opdivo and Yervoy in first-line non-small-cell lung cancer."
"Given Bristol now trails Merck (MRK) in launching an immuno-oncology drug in first-line NSCLC, catching up through combination treatment is more important," Conover said.
Also, Twitter reported disappointing fourth-quarter 2016 results, with total revenue and operating income below our expectations.
"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.
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 Honda Motor Co (HMC) to $29 per share from $26. As equity strategist Dave Whiston explains, the fair value change owes to the yen weakening against the dollar since our last valuation and higher midcycle operating margin.
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 Mead Johnson Nutrition to $86 per share (from $82), the discounted value of Reckitt Benckiser's (RBGLY) $90 per share cash offer to purchase Mead Johnson, assuming a Sept. 30 close. (When an acquisition is in the offing, the trading price in the market and our fair value estimate usually lags the takeout price to account for the risk that the acquisition could fall through. As the acquisition date approaches and the deal becomes more likely, the market price converges to the takeout price.) Equity analyst Zain Akbari notes his stand-alone valuation for Mead Johnson rose to $83 per share, reflecting a time value of money adjustment after on-track fourth-quarter earnings.
Similarly, we raised our fair value estimate for Linear Technology to $61 per share from $60, based on Analog Devices' (ADI) bid to acquire the firm for $46 in cash per share and 0.2321 shares of ADI stock, which we value at $66 per share. Colello believes the deal is on track to close in the next few months.
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 Weyerhaeuser (WY) and Rayonier (RYN) to incorporate a reduced near-term outlook for U.S. housing starts (explained here). 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 here). 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.
Karen Wallace does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.