Putting Fair Value Estimates in Context

Source: http://news.morningstar.com/articlenet/article.aspx?id=678493

Question: How do I use the price/fair value metric? And if the market is efficient, why isn’t the fair value estimate equal to the stock’s trading price?

Answer: The price/fair value ratio for stocks, found under the Valuation tab on individual stock pages, helps investors determine whether a stock is trading at, below, or above its fair value estimate, as determined by Morningstar’s equity analysts.

 

<p>To review, all stocks under coverage by Morningstar's equity analyst team receive a fair value estimate; the analysts forecast a company's future cash flows to arrive at an estimate of the company's intrinsic worth. If the fair value estimate for the stock, based on <a>the analysts' estimate of the company's intrinsic worth and the number of shares outstanding</a>, is $100 per share but the stock is trading at only $90 per share, then its price/fair value ratio is 0.90. If the stock is trading at $110 per share, its price/fair value ratio would be 1.1. A price/fair value ratio below 1 suggests the stock is trading at a discount to its fair value, while a ratio above 1 suggests it is trading at a premium to its fair value. </p>  <p><strong>The Value in Our Stars</strong>    <br />You can find a stock's fair value estimate by using the Quote search box at the top of this page. The page that comes up also includes &quot;consider buying&quot; and &quot;consider selling&quot; prices based on what our analysts consider to be a suitable margin of safety for buying or selling the stock. For stocks with higher fair value uncertainty ratings (in which future earnings are more difficult to estimate), this margin of safety is rather broad, whereas for those with narrow uncertainty ratings (in which future earnings are considered more knowable), the margin of safety is more narrow. </p>  <p>The price/fair value ratio, in combination with the fair value uncertainty rating, also determines the Morningstar Rating for stocks--or the number of stars the stock carries. This forward-looking measure assigns 4 or 5 stars to stocks trading at a meaningful discount to their fair value estimates, 3 stars to those trading close to their fair value estimates, and 1 or 2 stars to those trading meaningfully above their fair value estimates. (For more on the Morningstar Rating for stocks methodology, read <a href="http://news.morningstar.com/pdfs/Equity_Research_Methodology_102308.pdf">this document</a>.)</p>  <p>Fair value estimates also are computed for exchange-traded funds, ETFs, based on the underlying holdings that are under coverage by Morningstar analysts. (Stocks in the portfolio that are not covered are assumed to be fairly valued.) ETFs are given a valuation rating of undervalued, fairly valued, or overvalued, depending on where they are trading relative to their fair value estimates. (For more on fair value estimates for ETFs, read <a href="https://corporate.morningstar.com/us/documents/MarketingOneSheets/INS_ETF_ETFAnalystReportStructure.pdf">this document</a>.)</p>  <p><strong>Fair Value and Market Efficiency</strong>    <br />Now, on to the second part of your question: Some investors believe that the market is highly efficient, meaning that stocks are priced appropriately at any given moment based on the amount of information available at the time, and that this is true in particular for stocks that are heavily traded and, thus, closely watched. <a>Proponents of passive (index-based) investing and those who argue against trying to time the market sometimes cite this theory--known as the </a><a href="http://www.morningstar.com/InvGlossary/efficient_market_hypothesis_definition_what_is.aspx">Efficient Market Hypothesis</a>--in defending their position. Of course, not everyone agrees. Some point to the success of value investors such as Warren Buffett as evidence that the market doesn't always price stocks appropriately and that opportunities do arise to buy stocks at a discount relative to their true worth. </p>  <p>We won't try to settle the debate here, but let's address your question as to why stocks don't necessarily trade in line with their fair value estimates if the market is supposed to be efficient. </p>  <p><a href="http://corporate.morningstar.com/US/documents/MethodologyDocuments/MethodologyPapers/MorningstarEquityResearchMethodologyOverview_methodology.pdf">This document</a> details Morningstar's approach to rating stocks and describes the fair value estimate methodology as follows: First, it is purely an estimate of the intrinsic business value, rather than what other investors might temporarily be willing to pay for a stock, which can be influenced by behavioral psychology and marketwide factors. <a>Second, the fair value estimate represents the value today, as opposed to being a price target that estimates the price the stock might fetch in the next two to 12 months, depending on market conditions (analysts outside Morningstar often will provide such price targets).</a></p>  <p>In other words, what investors say the company is worth and what our analysts say it's worth can differ for various reasons, including prevailing market conditions that can send even the best of stocks into the dumps during a sell-off. (See the performances of many blue-chip stocks during the 2008 market crash for further evidence.) Also, while stock analysts at some other firms issue buy or sell recommendations based on what they think a stock will be trading for in the near future, the fair value estimate is based on what our analysts say is the current value of the business, factoring in future cash flows. It could take months or years for the stock to reach this fair value estimate--in fact, it might never reach the fair value estimate at all if it turns out our assumptions were wrong, or if business or economic conditions change.</p>  <p>The fair value estimate is a great tool to assess whether a stock is trading at, above, or below what our analysts think it's worth and to identify stocks that may be mispriced. But it's not a crystal ball. It is an estimate and should be used as such.
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