Ask the Expert

We explain some of the main reasons Morningstar equity analysts may adjust their assessment of a stock's intrinsic value.
By Karen Wallace | 03/04/17

Question: Why and when does Morningstar change fair value estimates for stocks?

About the Author
Karen Wallace is Morningstar’s director of investor education.

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 of a small tweak to our model based on 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 that 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 being 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 that dividends need to be excluded here because those are payouts 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 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). As the firm has mostly met our expectations, the increases have been driven by these time value of money expectations.

Increased optimism

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 US$138 per share from US$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 US$6 from US$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.

Decreased optimism

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 US$64 from US$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 (TWTR) 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 US$18 from US$20 given questions surrounding the company's ability to grow its user base.

Buyouts

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 (MJN) to US$86 per share (from US$82), to reflect the discounted value of  Reckitt Benckiser's (RBGLY) US$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 US$83 per share, reflecting a time value of money adjustment after on-track fourth-quarter earnings.

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. Equity sector director Daniel Rohr also notes that it is likely that the Trump administration will impose a stiff tariff on Canadian softwood lumber. As a result, we increased our fair value estimate for each company by US$1--Rayonier went to US$27 from US$26, and Weyerhaeuser went from US$35 from US$34.

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