Valuing Industries: A Different Approach

Valuing Industries: A Different Approach

While doing some work today, I ran across this resource from Morningstar. Morningstar values stocks by projecting the free cash flows of the companies, and discounting those free cash at a rate that reflects the riskiness of the company.  Free cash flows are the amount of cash you can take from a corporation over a period, an leave it equally well off as it was at the beginning of the period.  Some analysts summarize it as:

  • Earnings then add back
  • Interest, Taxation, Depreciation, Amortization, and subtract
  • Maintenance Capital Expenditure

When you see firms talk about their non-GAAP earnings, this is what some are trying to approximate, showing the true earnings power of the assets.

They project the free cash flows in three phases:

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  • Phase 1, the analyst projects the next five years
  • Phase 3, every company is the same, growing at the same rate with no competitive advantage
  • Phase 2 grades from Phase 1 to Phase 3, with wide moat companies having a transition period of 20 years, narrow moat companies 15 years, and “no moat” companies a lesser amount.

What does Morningstar use for its free cash flow discount rates?  They started with CAPM, and moved to something more simple, where companies are divided into four buckets, with rates of 8, 10, 12, and 14%.  I’m no fan of CAPM, but it would be a lot smarter to have a system that reflected:

  • the bond yields of the companies, if any, and
  • the relative riskiness of the enterprise without reference to the market as a whole.  The implied volatility of the stock could play a role.

At the end, Morningstar calculates the ratio of the current market price to the discounted value of the free cash flows per share.  If it is greater than one, is is overvalued.  If it less than one, undervalued.

Morningstar does the calculation company by company, but then aggregates the results by super sector, sector, industry, aize of moat, fair value uncertainty, and equity index.

What I particularly found interesting were the aggregations by industry.  I decided to look at the industries that  were overvalued and undervalued by at least 15%.  Here they are:


  • Aluminum
  • Asian Banks
  • Coal
  • Gold
  • Latin American Banks
  • Pollution & Treatment Controls
  • Steel


  • Auto & Truck Dealerships
  • Auto Parts
  • Broadcasting – Radio
  • Business Services
  • Computer Systems
  • Electronics Distribution
  • Financial Exchanges
  • Footwear & Accessories
  • Home Furnishings & Fixtures
  • Insurance Brokers
  • Internet Content & Information
  • Long-Term Care Facilities
  • Luxury Goods
  • Marketing Services
  • Medical Distribution
  • Regional US Banks
  • Regulated Gas Utilities
  • REIT – Hotel & Motel
  • Scientific & Technical Instruments
  • Semiconductor Memory
  • Solar
  • Trucking

Morningstar has 147 industries, of which only two did not have fair value estimates.  Seven industries were undervalued (5%), 22 industries were undervalued (15%).  The undervalued industries were mostly cyclical in nature, while the overvalued industries were not, supporting the idea of this Wall Street Journal article, which argues that cyclical stocks are looking relatively cheap.  It is possible to overpay for certainty, just as it is possible to overlever companies with reliable cash flow.

At this point you might be asking, “Okay, this is nice, but what companies does this imply I should buy or sell?”  Can’t tell you for sure,but I can show you this.  This table is interesting enough, but what you can get are the companies behind each industry group if you click on them.  Note that Morningstar is global in its orientation, so many of the companies that it uses are not US-domiciled.  Some may have nonsponsored ADRs that trade infrequently.

My main point is that you can look at the underlying companies of each industry for buy or sell ideas of of their own discount or premium to fair value.  Morningstar’s fair value analysis is not perfect, but it is a straw blowing in the  wind, and is adequate for some relative value judgments.

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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