?
Google, Inc. GOOG
Last Price
541.30 USD
Fair Value
550.00 USD
Consider Buy
275.00 USD
[Nasdaq]
Consider Sell
1100.00 USD
|
QQQ
Uncertainty
High
TM
Economic Moat
Wide
Stewardship
C
As the king of search, Google enjoys an enviable position.
by Larry Witt, CFA
Stock Analyst
Analysts covering this company do not
own its stock.
Pricing data through February 16, 2010.
Rating updated as of
February 16, 2010.
Currency amounts expressed with "$"
are in U.S. dollars (USD) unless
otherwise denoted.
Stock
Price
692.0
592.0
492.0
392.0
292.0
06
07
08
09
10
Thesis Jan. 22, 2010
Google’s dominance in Internet search has led to meteoric
revenue growth and fantastic profits. This profitability has
allowed the company to enter additional advertising
markets and new industries, including software as a
service and the mobile industry. Though we’re not
convinced the firm will replicate its current success in
these new markets, its profits from search advertising
should allow the company to generate copious cash flow
for many years.
Attracted by its measurability and effectiveness,
marketers have allocated more funds to paid search every
year. Although the U.S. search market has started to
mature, we think there is plenty of growth left in many
international markets. These growth opportunities bode
well for all industry participants, especially Google, which
had 67% global search market share compared with just
8% for second-place Yahoo as of July 2009, according to
ComScore. We think Google is poised to remain the leader
for a few reasons. First, the fact that "Google it" has
become synonymous with Internet search is a testament
to Google’s brand strength. Second, the firm has the
financial resources and engineering prowess to ensure its
search engine remains the best in the industry. Third,
Google’s massive scale of search queries and clicks gives
the company unparalleled insights into which search
results are most popular with users. This data intelligence
can be used to further tweak its algorithms, leading to
more relevant search results and an even better user
experience. For these reasons, we think the company has
a wide economic moat.
Paid search, which represents 85% of net revenue,
generates substantial cash flow for Google. The firm has
pursued new business lines into which it can deploy this
capital, including placing ads on third-party Web sites,
video ads on YouTube, and setting up a platform for the
buying and selling of television ad space. Unlike paid
Morningstar Credit Rating Industry
Internet Information Providers
.
search, Google has to share the vast majority of any
revenue it receives in these markets with the content
owner, leading to lower profit margins. Therefore, relative
to paid search, we think the opportunity for Google to earn
significant profits through these other ad platforms is
limited.
Google is also investing in emerging industries outside
advertising. For example, it has launched Google Apps, a
Web-based suite of office productivity applications aimed
at small businesses, to compete with Microsoft Office and
Outlook. Google has also developed Android, an operating
system for cell phones; Chrome, a Web browser; and the
Google App Engine, a cloud computing platform available
to third parties to develop and host Web applications.
While the brand may resonate with consumers, we don’t
think Google has superior competitive advantages outside
of Internet search. Therefore, the company will have to
invest heavily to succeed in what we think are inherently
lower-margin businesses. While this may lead to lower
overall returns on capital, we think Google’s core search
business will allow the company to remain very
profitable.
Valuation
We are raising our fair value estimate for Google to $550
per share from $500. This new fair value estimate implies
forward price/earnings of 21 times, price/cash flow from
operations of 17 times, and enterprise value/EBITDA of 13
times. The primary reason for our fair value upgrade is
slightly higher profitability assumptions and cash earned.
As search advertising continues to steal share from
traditional media, we forecast Google’s overall revenue to
increase at an average annual clip of 14% during the next
five years. Although we forecast that the majority of this
revenue growth will come from paid search, we also
expect Google to increase revenue from other business
lines, including third-party ad sales and online software.
Due to offsetting factors, we expect the operating margin
to remain relatively flat during our forecast period. We
Google, Inc. GOOG
Last Price
541.30 USD
Fair Value
550.00 USD
[Nasdaq]
|
QQQ
Consider Sell
1100.00 USD
Currency(Mil)
Market Cap
TTM Sales
Oper Income
Net Income
Google, Inc.
USD
172,122
23,651
8,312
6,520
Microsoft Corporation
USD
248,643
58,689
21,420
16,258
Yahoo, Inc.
USD
21,590
6,535
-10
142
IAC/InterActiveCorp
USD
2,851
1,360
-44
262
Close Competitors
Uncertainty
High
TM
Consider Buy
275.00 USD
Economic Moat
Wide
Stewardship
C
Morningstar data as of February 16, 2010.
project an operating margin of 35% in 2013 (compared
with our prior forecast of 34%). The main drag on margins
will be Google’s investments outside of its core business.
The company’s other business lines are inherently less
profitable, as they do not enjoy the economies of scale of
Google’s search platform. Therefore, we expect Google’s
expenditures on personnel and technology to continue
growing faster than revenue, which would imply lower
operating margins. However, Google’s lowest-margin
business is selling ads on third-party sites because in
addition to incurring operating costs, the majority of this
revenue must be paid to the content owner. These
payments are called TAC, or traffic acquisition costs.
Because we project this business to grow much more
slowly than the rest of the company, TAC expenditures
will decline as a percentage of sales, offsetting increased
operating expenses.
Risk
Switching costs are relatively low in Internet search, and
fickle consumers may move to a competitor that is able to
establish a stronger brand or a more useful experience.
Google is investing in new businesses where it is less
competitive, which may lead to a deterioration in its
operating margin and return on capital. Finally, the stock
options of many early employees have now vested.
Therefore, employee retention may become more difficult.
Morningstar Credit Rating Industry
Internet Information Providers
.
Bulls Say
Online advertising is growing very quickly as large
advertisers are increasingly attracted by its
measurability and its high returns on investment.
Because of its effectiveness and measurability, we
think paid search would be the least affected, though
not immune, form of advertising in an economic
downturn.
Google has a superior technical staff that will continue
to innovate faster and better than the competition.
Google’s brand strength should help attract customers
to try its new products like online software, Google
Checkout, and its mobile platform.
Google’s massive cash position, profitability, and
corporate image allow the company to outbid
competitors when it comes to acquiring hot
technologies and key personnel.
Bears Say
Other than brand strength, there are very few switching
costs in Internet search. Google would suffer if a
competitor could develop a superior search engine and
gain marketing buzz.
New business lines for Google will be less profitable,
and any significant investment may ultimately destroy
shareholder value.
Large, expensive efforts like Google Earth digital
mapping software may enhance Google’s image but will
do little to generate additional revenue for the
company.
Now that many key employees are financially
independent, long-term employee retention may
become more difficult.
After acquiring YouTube, Google may be constantly
distracted by lawsuits claiming digital copyright
infringement.
© 2010 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported.
The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.
Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
®
ß
Google, Inc. GOOG
Last Price
541.30 USD
Fair Value
550.00 USD
Consider Buy
275.00 USD
[Nasdaq]
Consider Sell
1100.00 USD
|
QQQ
Uncertainty
High
TM
Economic Moat
Wide
Stewardship
C
Financial Overview
Growth: Annual revenue growth has averaged an
astounding 102% per year since 2001 as the company
helped define the paid search industry and built the
largest syndicate of advertisers and content partners. We
expect revenue growth to average a more modest 14%
over the next five years.
Profitability: By cutting non-essential costs, Google’s
operating margin was 35% in 2009, up from 30% in 2008.
We expect operating margins to remain relatively flat
during our forecast period as the company resumes
spending on non-core initiatives.
Morningstar Credit Rating Industry
Internet Information Providers
.
previously been CEO of Novell and chief technology officer
of Sun Microsystems. Many have heralded the unorthodox
decision-making led by this three-person committee, but
we question its sustainability, particularly if Schmidt were
to leave. We believe Schmidt plays a critical role in the
success of the company that highlights the talents of each
of the leaders. Page, Brin, and Schmidt have two thirds of
the equity voting rights as of the last proxy filing because
of a dual-class structure. This disproportionate voting
power is a significant risk for the remaining equity
shareholders. We believe management could be more
forthcoming with regard to its long-term strategy and
operating metrics of the business.
Financial Health: The balance sheet is rock-solid, with $25
billion of cash and no debt.
Company Overview
Profile: Google provides a free search engine for users
around the world and generates revenue whenever a user
clicks on a text ad displayed alongside the search results.
This represents 85% of the company’s net revenue. The
remaining 15% of net revenue is derived from ads sold on
third-party sites and online software. Google is also
investing in new business lines including traditional media
advertising, the mobile industry, and online software.
Strategy: Using behavioral insights, demographic data,
and geographic targeting, Google wants to provide highly
relevant advertising across a variety of media; the more
relevant the advertising, the more advertisers are willing
to pay. Google is also trying to leverage its brand strength
and massive financial resources to enter new markets
outside of advertising.
Management: Larry Page and Sergey Brin founded Google
in 1998 and now lead the company as a triumvirate with
Eric Schmidt, who has been CEO since 2001. Schmidt had
© 2010 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported.
The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.
Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
®
ß
Google, Inc. GOOG
Last Price
541.30 USD
Fair Value
550.00 USD
Consider Buy
275.00 USD
[Nasdaq]
Consider Sell
1100.00 USD
|
QQQ
Uncertainty
High
TM
Economic Moat
Wide
Stewardship
C
Morningstar Credit Rating Industry
Internet Information Providers
.
Analyst Notes
Jan. 21, 2010
First Impression of Google’s 4Q
Google reported solid fourth-quarter results on Thursday.
We expect to modestly raise our fair value estimate as a
result of slightly higher profitability assumptions and cash
earned. Overall revenue increased 17% in the quarter (13%
excluding currency fluctuations) to $6.7 billion. We think
these results support our thesis that search advertising will
continue to steal market share from traditional media and
that Google is best-positioned to capture this shift. While
Google’s revenue growth is notable, the company’s
profitability has been more impressive. Operating margin
reached an all-time high of 37% in the quarter, compared
Jan. 13, 2010
Google May Click Away From China
Google announced on Tuesday that it was reviewing its
business in China and could shut down its local operations
due to recent cyber attacks and ongoing censorship
disputes with the Chinese government. Since launching
Google.cn in 2006, Google has struggled with the choice
between their principle of free speech and potential profits
in China. The company does not agree with the mandated
censoring of their search results. We expect the censorship
issue to be an ongoing source of contention between
Google and the Chinese government. We think Google has
Oct. 15, 2009
with 33% a year ago as the company cut nonessential costs
during the recession. Coupled with lower capital
expenditures, these cost cuts allowed the company to
generate $8.5 billion in free cash flow in 2009, or 49% of
its revenue. Although we expect capital expenditures and
operating expenses to pick up as the ad market improves,
we are likely to raise our long-term profitability
assumptions, leading to a slightly higher fair value
estimate.
been willing to agree to these censorship rules over the
past few years because China represents such a large
potential growth opportunity. However, China currently
represents an immaterial portion of Google’s overall
business, and we think the company has plenty of growth
potential in other markets. We will be closely monitoring
the situation, but we do not plan on changing our fair value
estimate for Google if the company ends up shuttering its
operations in China.
First Impression of Google
Google posted a solid quarter on a number of metrics:
revenue, cost discipline, and cash flow. At first glance, we
don’t expect a meaningful change, if any, to our fair value
estimate. Reported revenue increased 7% (12% excluding
currency effects) to $5.9 billion. This growth is a slight
acceleration from that of the last two quarters, potentially
indicating that the worst of the advertising environment is
over. Google also continued to cut costs. Operating costs
were down, driven by reduced head count. Therefore, the
operating margin reached 35% compared with 30% in the
year-ago quarter. The improved profitability combined with
lower capital expenditures allowed the company to turn
43% of its revenue into free cash flow during the quarter,
compared with 23% in the prior-year quarter. Although we
expect capital expenditures to pick up at some point,
Google’s ability to markedly improve profitability during a
period of weak revenue growth is impressive and has
surpassed our expectations.
© 2010 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported.
The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.
Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
®
ß
Google, Inc. GOOG
Last Price
541.30 USD
Fair Value
550.00 USD
Consider Buy
275.00 USD
[Nasdaq]
Consider Sell
1100.00 USD
|
QQQ
Uncertainty
High
TM
Economic Moat
Wide
Stewardship
C
Morningstar Credit Rating Industry
Internet Information Providers
.
Analyst Notes (continued)
Sept. 04, 2009
Google China President Resigns
Google global vice president and China president Kaifu Lee
has resigned from his position. It’s reported that he will set
up a new venture fund to help Chinese entrepreneurs. Lee
joined Google to develop the company’s operations in China
in 2005 and has been instrumental in building the
engineering and sales teams for the Chinese market.
Though it is unclear to us whether the Chinese
government’s criticism of Google over access to
pornographic content in June is one of the reasons causing
Lee to leave, we think this incident, together with Lee’s
resignation, reflects the difficulties that a foreign search
engine faces in the Chinese market. In addition, we saw a
widening gap between the number-one player Baidu and
Google China in terms of search queries over the past few
quarters. According to iResearch, Google China’s market
share of search queries declined to 19.8% in the second
quarter from 23% in the fourth quarter of 2008. Meanwhile,
Baidu’s share rose to 75.7% from 72%. We think the
changing competitive dynamics in the Chinese search
market appear more favorable for Baidu. As such, we’re
putting Baidu under review while digging further into the
evolving market trends.
Disclaimers & Disclosures
No Morningstar employees are officers or directors of this company. Morningstar Inc. does not own more than 1% of the shares of this company. Analysts
covering this company do not own its stock. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely.
This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.
© 2010 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported.
The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.
Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
®
ß
Morningstar ® Stock Data Sheet
Pricing data thru Feb. 16, 2010
Google, Inc. GOOG
Sales USD Mil Mkt Cap USD Mil Industry
Google provides a free search engine for users around the
world and generates revenue whenever a user clicks on a
text ad displayed alongside the search results. This
represents 85% of the company’s net revenue. The
remaining 15% of net revenue is derived from ads sold on
third-party sites and online software. Google is also
investing in new business lines including traditional media
advertising, the mobile industry, and online software.
Morningstar Rating
Last Price
541.30
QQQ
Rating updated as of Feb. 16, 2010
Fiscal year-end: December
Sector
23,651
172,122
Internet
Telecommunications
Information Providers
Fair Value
Uncertainty
Economic Moat
550.00
High
TM
Stewardship Grade
Wide
C
per share prices in USD
201.60 446.21 513.00 747.24 697.37 625.99 629.51
95.00 172.57 331.55 437.00 247.30 282.75 522.46
Annual Price High
Low
Recent Splits
Price Volatility
199.0
1600 Amphitheatre Parkway
Mountain View, CA 94043
Phone: 1 650 623-4000Website: http://www.google.com
2000
2001
2002
2003
1 Yr
3 Yr
5 Yr
10 Yr
8.5
25.3
53.3
.
26.5
51.3
-11.7
27.9
30.6
32.8
27.1
.
26.8
4.8
2.6
12.5
49.3
67.0
69.5
.
60.3
22.2
10.6
23.8
.
.
.
.
.
.
.
.
Current
5 Yr Avg
Ind
Mkt
-15
7
100
Return on Equity %
20.3
21.0
10.0
Return on Assets %
18.1
19.0
8.4
Fixed Asset Turns
4.7
6.0
4.7
Inventory Turns
.
. 1277.0
Revenue/Employee USD K1192.4 1085.9 *
.
16.0
6.3
6.8
11.7
803.0
-0.22
.
67
.
0.04
.
186
.
0.41
.
256
.
.
.
.
.
.
.
155
-37
118
Revenue %
Operating Income %
Earnings/Share %
Dividends %
Book Value/Share %
Stock Total Return %
+/- Industry
+/- Market
Profitability Analysis
Grade: C
Gross Margin %
Operating Margin %
Net Margin %
Free Cash Flow/Rev %
R&D/Rev %
62.6
35.1
27.6
36.0
12.0
60.3
32.5
25.0
24.8
0.1
59.1
15.5
13.7
22.2
.
38.9
13.3
7.1
0.0
11.2
Financial Position
Grade: A
12-08 USD Mil
12-09 USD Mil
Cash
Inventories
Receivables
Current Assets
8657
.
2642
20178
10198
.
3202
29167
Fixed Assets
Intangibles
Total Assets
5234
5837
31768
4845
5678
40497
178
.
2302
.
3529
216
.
2747
1392
4493
28239
36004
Payables
Short-Term Debt
Current Liabilities
Long-Term Debt
Total Liabilities
Total Equity
Valuation Analysis
Price/Earnings
Forward P/E
Price/Cash Flow
Price/Free Cash Flow
Dividend Yield %
Price/Book
Price/Sales
PEG Ratio
.
.
.
.
.
2004
2005
2006
5 Yr Avg
Ind
Mkt
26.5
17.7
18.6
20.3
.
4.8
7.3
0.8
46.9
.
32.5
53.6
.
7.9
12.0
.
43.9
.
18.6
26.5
.
4.2
5.9
.
11.6
13.6
3.5
10.0
2.0
2.2
0.9
1.6
*3Yr Avg data is displayed in place of 5Yr Avg
10 Year High/Low
747.24 - 95.00
19.0
Bear-Market Rank
0 (10=worst)
2008
2009
YTD
-55.5 101.5
-12.7
-59.0 140.0
-36.1
0.0
-0.3
-3.4
0.0
.
.
96834 197012 172122
Trading Volume Million
Stock Performance
Total Return %
+/- Market
+/- Industry
Dividend Yield %
Market Cap USD Mil
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
TTM
19
68.2
-15
-77.1
86
83.5
11
12.7
440
70.1
186
42.4
1466
57.3
342
23.4
3189
54.3
640
20.1
6139
58.1
2017
32.9
10605
60.2
3550
33.5
16594
59.9
5084
30.6
21796
60.4
6632
30.4
23651
62.6
8312
35.1
23651
62.6
8312
35.1
Revenue USD Mil
Gross Margin %
Oper Income USD Mil
Operating Margin %
106
399
1465
3077
4204
4227
6520
6520
Net Income USD Mil
0.41
.
256
.
1.46
.
272
10.71
5.02
.
291
31.87
9.94
.
309
55.66
13.29
.
316
72.53
13.31 20.41 20.41
.
.
.
393
319
319
89.72 113.30 113.48
Earnings Per Share USD
Dividends USD
Shares Mil
Book Value Per Share USD
395
-177
219
977
-319
658
2459
-838
1621
3581
-1903
1678
5775
-2403
3373
7853
-2358
5494
9316
-810
8506
9316
-810
8506
Oper Cash Flow USD Mil
Cap Spending USD Mil
Free Cash Flow USD Mil
Financials
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
TTM
Profitability
-31.3
-53.9
-76.9
0.41
1.7
.
.
8.1
.
.
34.7
76.9
22.7
1.53
2.2
18.2
31.4
7.2
2.53
1.6
19.1
23.0
12.5
1.52
1.1
21.6
23.7
23.9
0.90
1.1
21.4
23.3
29.0
0.74
1.1
19.2
21.2
25.3
0.76
1.1
14.8
16.6
19.4
0.76
1.1
18.1
20.3
27.6
0.65
1.1
18.1
20.3
27.6
0.65
1.1
Return on Assets %
Return on Equity %
Net Margin %
Asset Turnover
Financial Leverage
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
12-09
Financial Health
.
.
27
.
.
.
.
.
142
7
174
0.05
325
.
589
0.00
2353
.
2929
.
8256
.
9419
.
11735
.
17040
.
15254
.
22690
.
17876
.
28239
.
26419
1392
36004
0.04
26419
1392
36004
0.04
Working Capital USD Mil
Long-Term Debt USD Mil
Total Equity USD Mil
Debt/Equity
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
TTM
Valuation
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
131.6
6.2
16.5
18.0
53.8
82.6
4.3
19.4
13.0
48.5
46.3
2.7
13.3
8.3
39.5
52.1
3.1
13.2
9.5
37.9
23.1
1.4
5.5
3.4
15.4
30.4
2.8
8.4
5.5
21.3
26.5
2.3
7.3
4.8
18.6
Price/Earnings
P/E vs. Market
Price/Sales
Price/Book
Price/Cash Flow
Quarterly Results
Current
2007
11.0
50.2
. 115.2
8.0
36.6
. 106.2
71.6
8.4
11.6
.
.
.
.
.
52712 122611 140979 216323
52 week High/Low
629.51 - 289.45
49.0
9.0
4.0
Growth Rates Compound Annual
Grade: A
Monthly High/Low
Rel Strength to S&P 500
499.0
Revenue USD Mil
Most Recent Period
Prior Year Period
Rev Growth %
Most Recent Period
Prior Year Period
Earnings Per Share USD
Most Recent Period
Prior Year Period
Industry Peers by Market Cap
Mar 09
Jun 09
Sep 09
Dec 09
6673.8 6673.8 6673.8 6673.8
5700.9 5700.9 5700.9 5700.9
Mar 09
Jun 09
Sep 09
Dec 09
17.1
18.1
17.1
18.1
17.1
18.1
17.1
18.1
Mar 09
Jun 09
Sep 09
Dec 09
4.49
4.12
4.66
3.92
5.13
4.06
6.14
1.21
Mkt Cap USD Mil Rev USD Mil
Google, Inc.
Microsoft Corporatio
Yahoo, Inc.
172122
248643
21590
P/E
ROE%
23651 26.5
58689 15.6
6535 .
20.3
41.3
1.2
Major Fund Holders
% of shares
American Funds Growth Fund of Amer A
Fidelity Contrafund
Fidelity Growth Company
3.02
1.98
0.74
TTM data based on rolling quarterly data if available; otherwise most recent annual data shown.
© 2010 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported.
The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.
Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
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Morningstar’s Approach to Rating Stocks
Our Key Investing Concepts
Economic Moat Rating
Discounted Cash Flow
Discount Rate
Fair Value
Uncertainty
Margin of Safety
Consider Buying/Consider Selling
Stewardship Grades
TM
At Morningstar, we evaluate stocks as pieces of a
business, not as pieces of paper. We think that purchasing
shares of superior businesses at discounts to their
intrinsic value and allowing them to compound their value
over long periods of time is the surest way to create
wealth in the stock market.
just on movement in the share price. If we think a stock’s
fair value is $50, and the shares decline to $40 without
much change in the value of the business, the star rating
will go up. Our estimate of what the business is worth
hasn’t changed, but the shares are more attractive as an
investment at $40 than they were at $50.
We rate stocks 1 through 5 stars, with 5 the best and 1
the worst. Our star rating is based on our analyst’s
estimate of how much a company’s business is worth per
share. Our analysts arrive at this "fair value estimate" by
forecasting how much excess cash--or "free cash
flow"--the firm will generate in the future, and then
adjusting the total for timing and risk. Cash generated
next year is worth more than cash generated several years
down the road, and cash from a stable and consistently
profitable business is worth more than cash from a
cyclical or unsteady business.
Because we focus on the long-term value of businesses,
rather than short-term movements in stock prices, at times
we may appear out of step with the overall stock market.
When stocks are high, relatively few will receive our
highest rating of 5 stars. But when the market tumbles,
many more will likely garner 5 stars. Although you might
expect to see more 5-star stocks as the market rises, we
find assets more attractive when they’re cheap.
Stocks trading at meaningful discounts to our fair value
estimates will receive high star ratings. For high-quality
businesses, we require a smaller discount than for
mediocre ones, for a simple reason: We have more
confidence in our cash-flow forecasts for strong
companies, and thus in our value estimates. If a stock’s
market price is significantly above our fair value estimate,
it will receive a low star rating, no matter how wonderful
we think the business is. Even the best company is a bad
deal if an investor overpays for its shares.
Our fair value estimates don’t change very often, but
market prices do. So, a stock may gain or lose stars based
Morningstar Research
Methodology for Valuing
Companies
Competitive
Analysis
Economic
TM
Moat Rating
Analyst conducts
company and industry
research:
The depth of the
firm’s competitive
advantage is rated:
Management
interviews
Conference calls
Trade-show visits
Competitor, supplier,
distributor, and
customer interviews
None
Narrow
Wide
We calculate our star ratings nightly after the markets
close, and issue them the following business day, which is
why the rating date on our reports will always be the
previous business day. We update the text of our reports
as new information becomes available, usually about once
or twice per quarter. That is why you’ll see two dates on
every Morningstar stock report. Of course, we monitor
market events and all of our stocks every business day, so
our ratings always reflect our analyst’s current opinion.
TM
Economic Moat Rating
TM
The Economic Moat Rating is our assessment of a firm’s
ability to earn returns consistently above its cost of capital
in the future, usually by virtue of some competitive
advantage. Competition tends to drive down such
Company
Valuation
Fair Value
Estimate
Analyst considers
company financial
statements and
competitive position
to forecast future
cash flows.
DCF model leads to
the firm’s Fair Value
Estimate, which
anchors the rating
framework.
Uncertainty
Assessment
An uncertainty
assessment
establishes the
margin of
safety required for
the stock rating.
QQQQQ
Q
QQ
QQQ
QQQQ
QQQQQ
The current stock
price relative to fair
value, adjusted
for uncertainty,
determines the
rating.
Assumptions are
input into a discounted cash-flow
model.
© 2010 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported.
The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.
Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
®
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Morningstar’s Approach to Rating Stocks (continued)
economic profits, but companies that can earn them for an
extended time by creating a competitive advantage
possess an Economic Moat. We see these companies as
superior investments.
Very High, or Extreme. The greater the level of uncertainty,
the greater the discount to fair value required before a
stock can earn 5 stars, and the greater the premium to fair
value before a stock earns a 1-star rating.
Discounted Cash Flow
Margin of Safety
This is a method for valuing companies that involves
projecting the amount of cash a business will generate in
the future, subtracting the amount of cash that the
company will need to reinvest in its business, and using
the result to calculate the worth of the firm. We use this
technique to value nearly all of the companies we cover.
This is the discount to fair value we would require before
recommending a stock. We think it’s always prudent to
buy stocks for less than they’re worth.The margin of safety
is like an insurance policy that protects investors from bad
news or overly optimistic fair value estimates. We require
larger margins of safety for less predictable stocks, and
smaller margins of safety for more predictable stocks.
Discount Rate
We use this number to adjust the value of our forecasted
cash flows for the risk that they may not materialize. For a
profitable company in a steady line of business, we’ll use
a lower discount rate, also known as "cost of capital,"
than for a firm in a cyclical business with fierce
competition, since there’s less risk clouding the firm’s
future.
Consider Buying/Consider Selling
The consider buying price is the price at which a stock
would be rated 5 stars, and thus the point at which we
would consider the stock an extremely attractive
purchase. Conversely, consider selling is the price at
which a stock would have a 1 star rating, at which point
we’d consider the stock overvalued, with low expected
returns relative to its risk.
Fair Value
This is the output of our discounted cash-flow valuation
models, and is our per-share estimate of a company’s
intrinsic worth. We adjust our fair values for off-balance
sheet liabilities or assets that a firm might have--for
example, we deduct from a company’s fair value if it has
issued a lot of stock options or has an under-funded
pension plan. Our fair value estimate differs from a "target
price" in two ways. First, it’s an estimate of what the
business is worth, whereas a price target typically reflects
what other investors may pay for the stock. Second, it’s a
long-term estimate, whereas price targets generally focus
on the next two to 12 months.
Stewardship Grades
We evaluate the commitment to shareholders
demonstrated by each firm’s board and management team
by assessing transparency, shareholder friendliness,
incentives, and ownership. We aim to identify firms that
provide investors with insufficient or potentially
misleading financial information, seek to limit the power
of minority shareholders, allow management to abuse its
position, or which have management incentives that are
not aligned with the interests of long-term shareholders.
The grades are assigned on an absolute scale--not relative
to peers--and can be interpreted as follows: A means
"Excellent," B means "Good," C means "Fair," D means
"Poor," and F means "Very Poor."
Uncertainty
To generate the Morningstar Uncertainty Rating, analysts
consider factors such as sales predictability, operating
leverage, and financial leverage. Analysts then classify
their ability to bound the fair value estimate for the stock
into one of several uncertainty levels: Low, Medium, High,
© 2010 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported.
The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.
Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
®
ß