How Does Morningstar Assign Stars?

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How Does Morningstar Assign Stars?

The Morningstar Rating for stocks is based on a stock's market price relative to its Fair Value Estimate, adjusted for uncertainty. Generally speaking, stocks trading at large discounts to Morningstar's analysts' fair value estimates will receive higher (4 or 5) star ratings, and stocks trading at large premiums to their fair value estimates will receive lower (1 or 2) star ratings. Stocks that are trading very close to the analysts' fair value estimates will usually get 3-star ratings.

Things to keep in mind

Not all companies are created equal, which is a reason that Morningstar created our Uncertainty Rating for stocks. The Uncertainty Rating represents the analysts' ability to bound the estimated value of the shares in a company around the Fair Value Estimate, based on the characteristics of the business underlying the stock, including operating and financial leverage, sales sensitivity to the overall economy, product concentration, pricing power, and other company-specific factors.

Our recommended margin of safety—the discount to fair value demanded before we'd recommend buying or selling the stock—widens as our uncertainty of the estimated value of the equity increases. Our uncertainty ratings are Low, Medium, High, Very High, and Extreme. The more uncertain we are about the estimated value of the equity, the greater the discount we require relative to our estimate of the value of the firm before we would recommend the purchase of the shares.

In very rare cases, the potential outcomes for a firm's intrinsic value become so disparate and volatile that a proper margin of safety cannot be properly estimated. For these speculative situations, we assign companies an uncertainty rating of Extreme. Using our best estimates, we publish fair values on these firms, but because of the extreme uncertainty surrounding these companies, we fix the stock rating at 3 stars regardless of stock price movements.

How to think about returns

When investing in any asset, you should expect a return that adequately compensates you for the risks inherent in the investment. Assuming that the stock's market price and fair value eventually converge, 3-star stocks should offer a "fair return." A fair return is one that adequately compensates you for the riskiness of the stock. Put another way, 3-star stocks should offer investors a return that's roughly equal to the stock's cost of equity. The cost of equity is often called the "required return," because it represents the return an investor requires for taking on the risk of owning a stock.

On the other hand, 5-star stocks should offer an investor a return that's well above the company's cost of equity. High-risk, 5-star stocks should also offer a better expected return than low-risk, 5-star stocks. Conversely, low-rated stocks have significantly lower expected returns. If a stock drops to 1 star, that means it is expected to lose money for investors based on Morningstar's assessment of the stock's fair value.

It is important to remember that if a stock's market price is significantly above the fair value estimate, it will receive a lower star rating, no matter how wonderful one thinks the business or its management is. Even the best company is a poor investment if an investor overpays for its shares.