How to Use Morningstar Ratings to Find Quality Stocks

Question: How does the stock star rating work?

Answer: To fully understand the star rating and how you might use it as a consider-buying gauge, it might help to get a brief background on how a few analyst-driven Morningstar ratings are determined and how they work together.

The Star Rating Let's start with the star rating, whose official name is the Morningstar Rating for stocks. This is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value. The bigger the discount, the higher the star rating. Our rating system also factors in an uncertainty adjustment (known as the fair value uncertainty rating--more on that below) so that it's more difficult for a company to earn a 5-star rating the less confident we are in the precision of our fair value estimate.

Fair Value Uncertainty When Morningstar equity analysts assign a fair value estimate to a stock, it's a single dollar-value estimate. But in actuality, our analysts predict of a range of outcomes or scenarios for each company when determining its fair value estimate. Our uncertainty rating follows the principals of a confidence interval, surrounding our fair value estimate. Essentially, a low fair value uncertainty rating means that the analyst thinks he or she can more tightly bound the fair value of a company because he or she can estimate its future cash flows with a greater degree of confidence. In determining this rating, our analysts score companies based on sales predictability, operating leverage, financial leverage, and exposure to contingent events (for example, a biotech company's success or failure may hinge on whether a single drug is approved or not).

(Note: This rating is sometimes referred to in shorthand as the "uncertainty rating," which may lead some people to assume the measure is intended to predict the future volatility of the stock's price. Although that is not the intent of the rating, some of the elements that go into determining the fair value uncertainty rating, such as leverage and risk of events such as litigation, could arguably result in a more volatile stock price.)

To illustrate how the rating works, let's look at two companies: The first,

At the other extreme is

Economic Moat The idea of an economic moat (a term originally coined by Warren Buffett) refers to how likely a company is to keep competitors at bay for an extended period. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors, and it's this characteristic--think of it as the strength and sustainability of a firm's competitive advantage--that Morningstar is trying to capture with the economic moat rating. A company that has generated capital higher than its cost of capital for many years probably has a moat, especially if its returns on capital have been rising or are fairly stable. Here are some things that can give companies economic moats:

Putting It All Together

The proprietary Morningstar ratings mentioned above can help you narrow your focus to find high-quality stocks that have a good chance of outperforming peers. In addition, the more comprehensive Stock Analyst Reports can provide valuable research that can help you make your investment decision. But after a six-year bull market, bargains are scarce. I used the Premium Stock Screener to search our entire coverage universe of stocks for those rated 5 stars, along with a fair value uncertainty rating of "low," and a wide economic moat rating. Out of more than 950 stocks we rate, there are only two in our coverage universe that currently meet these stringent criteria--energy firms

Dropping the 5-star criterion yields a list of 37 stocks, however. (Premium Members can

to see the results of the screen.) Though most of these stocks are not screaming buys at this point, our Portfolio Manager tool makes it easy to set up a watchlist for stocks that pique your interest. Just

, select New Watch List, enter the tickers, save, and you're done. (The share number, purchase price, and commission fields can be left blank.) You can customize your watchlist alerts to tell you about price swings or, if you're a Premium Member, you can be alerted whenever a new fair value estimate or Analyst Report is published.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.