How to Apply Valuation, Moat Analysis and Uncertainty Checks to Your Investing Like Morningstar by Jae Jun, Old School Value
I love Morningstar.
I hope that Old School Value will be a better version of Morningstar for value investors one of these days, but until then, I always find myself using their tools.
Previously, I showed you 15 of the best sites to collect ideas, but I was looking through Morningstar’s database the other day and found a list of stocks that got my interest.
Instead of just screening for the regular low PE and low PB, you can use their internal ratings to screen for stocks based on things like moat rating.
You have to pay to use this service though.
But if you’re short on time and want to a low hassle way of keeping up with large cap Buffett style businesses, it’s a great place to get ideas.
So that’s what I was doing and I added an additional filter to look for stocks with 4 stars or above in addition to having a wide moat.
And then it got me thinking about how Morningstar looks at stocks.
After all, if I want this site to be like Morningstar one day, I need to have an idea of how they value and analyze stocks.
So let’s examine how you can apply a fair value rating, moat analysis and uncertainty rating to your investing, just like how it’s shown at the Morningstar website.
Here’s what I saw for Apple Inc. (NASDAQ:AAPL) and what got me curious.
Since my intrinsic value for AAPL is much higher at $140 and I believe their economic moat is wider, I want to know how these values came up.
And by reverse engineering a process, it really forces you to dig deep and ask questions on the hows and whys.
Inverted thinking really is a powerful way of learning.
Getting the Valuation Correct
Morningstar’s Fair Value Method
Starting with fair value, according to its glossary;
It is the Morningstar analyst’s estimate of what the stock is worth. The Fair Value Estimate should be used in conjunction with our Economic Moat rating and our Business Risk rating.
Doesn’t tell you much.
But from what I can gather based on testing various inputs and the results I’m getting, it looks to be an internal DCF model with growth estimates based on analyst numbers.
I could be completely wrong but as I try to reverse engineer their fair values, it does feel very close.
Since a DCF is industry standard, I’m just starting with the DCF calculator, starting off with an assumed FCF, using a 9% discount rate and then playing around with the growth rates to get a value that matches their fair value.
Then I compare the final growth rate I’m seeing with the consensus analyst growth rate.
The results are fairly close. You’d be surprised that despite how firms say that they have a proprietary model, it’s doesn’t differ much from a 2 or 3 stage DCF.
After writing all this, I found an article which explains Morningstar’s method of valuing stocks which is exactly I expected.
An internal DCF with analyst inputs.
Old School Value’s Fair Value Method
I have two philosophies when it comes to valuing stocks.
- Keep it transparent
- Master multiple valuation methods and use the correct one for the situation
Sure, there’s no need to disclose what stocks you hold and how much you own, but when it comes to valuing stocks and performing analysis, there’s no reason to hide behind a black veil of secrecy.
No matter how good a valuation technique is, it’s never 100% accurate.
And if it’s not 100% accurate, why bother trying to keep something that doesn’t work all the time a secret?
Since I want to compare my estimates with that of Morningstar’s on 5 stocks that caught my eye, my fair value estimates are the averages of the DCF, Graham’s Formula, EBIT Mulitples and Absolute PE valuation method.
I keep all models transparent so that you can see everything from how it’s built, what the inputs are and even adjust the formulas yourself.
How to Apply a Moat Rating To Your Thesis
I’ve always liked how Morningstar displays their information, and their moat system is just one of them.
It’s simple and to the point.
Too bad it’s another “proprietary Morningstar data point.”
At least you can go to their glossary and read their well summarized take on the different moats and get an idea of how they rate a stock.
I have a couple of articles on measuring moats which you can read for later too.
- What gross margins can tell you about a company’s economic moat
- Summary of The Little Book that Builds Wealth
One quick way I measure moats is by comparing the Net Reproduction Value with the Earnings Power Value that Bruce Greenwald teaches in his value investing class at Colombia University.
I do the same thing in the OSV analyzer.
Book value, the net reproduction value and the EPV are compared to determine whether the company has a moat or not.
- A wide moat is a company where the EPV is much higher than the net reproduction value.
- A narrow moat is where the EPV is only slightly higher than the net reproduction value.
- No moat is where the EPV and net reproduction value are equal.
- A value destroyer is where the EPV is less than the net reproduction value.
In this example, a moat clearly exists, but it’s not as high as it used to be.
The chart is for IBM by the way. A year ago, the EPV was much higher, so it’s an indication that IBM’s moat is eroding slowly.
Compare it to this chart.
The EPV is shooting through the roof here.
This is what you call a moat.
The company is The Western Union Company (NYSE:WU).
Now this is just one way of coming up with a moat. You could follow a more qualitative process of reading through reports, books, newspapers and getting a better understanding of the entire company and industry.
Then either grading it an A to F or draw up a neat spider chart, which happens to be my method of choice.
The bigger the surface area, the bigger the moat, and better the investment.
Compare it to the many companies that look like this.
Get creative with how you want to represent your moat.
But try to keep it simple so that a single glance can tell the entire story.
Using an Uncertainty Rating
I first saw this in 2008 and