Last week, Morningstar held a workshop that taught its method for deriving an equity’s fair value, its “consider buying price” and its “consider selling price.” Since Morningstar’s ratings are widely used, I thought that it might be useful to apply their methods to securities that they do not cover. I was looking forward to gaining additional insights into equity valuation, but instead, I left a bit shaken and appalled. My opinion in Morningstar was greatly diminished.

*A Brief Description of the Method*

The Morningstar method attempts to find fair value by discounting the future free cash flows of a company, and then it uses financial ratios to get an “uncertainty measure.” They claim that the “consider selling price” and the “consider buying price” are derived from the “uncertainty measure.” If the uncertainty rating is high then the “consider buying price” is 50% of fair value and likewise, for a medium uncertainty rating the “consider buying price is 70% of fair value.

Morning Star takes a “cookbook” approach to equity valuation and never gives the rational behind its method. The staff cannot explain the reason that their method works. It is a three staged approach. In the first stage, historical free cash flows are computed. This is tax adjusted EBITA plus depreciation minus capital expenditures plus any contribution to cash from changes in working capital items such as decreases in inventories, or accounts receivables. Before stage II, the Weighted Average Cost of Capital (OTC:WACC) is derived. This is a weighted return where the weights are the debt and equity share of the firm’s value. An assumption is then made on the share of free cash that is re invested in the firm, the return on this invested capital, and the expected growth in earnings before interest (EBI). Next they assume that there is a future “perpetuity” date where earnings will grow at a certain rate until that date, and will grow at a different rate afterwards. Stage II computes the discounted value of the free cash flow from now until the perpetuity date. Stage III computes the value after the perpetuity date.

The staff at Morningstar never explained how one derives the “perpetuity date,” the growth rate estimate for EBI between now and the “perpetuity date”, and the growth rate afterwards. The staff claims that the uncertainty rating is a function of both operating and financial leverage, but they never explained how they used these financial indicators to derive it. When I asked for a documented derivation, they told me that it was “more art than science.”

*The Pitfalls*

There are several problems with this approach.

1) The intrinsic value of a firm is the value that a buyer is willing to pay for the firm minus its debt. The WACC that Morningstar claims to derive is not necessarily the return that a potential buyer will use to discount the future free cash flows of the firm.

2) A potential buyer is concerned about future free cash flow and not past ones. Assuming an annually constant growth rate for future cash flows is at best reckless. Future free cash flows are random variables that cannot be predicted with precise accuracy. They vary over time. The risk lies in the variance of possible free cash flow growth paths. Financial ratios such as debt/equity are signals of risk, but they are not variance measures themselves. Financial ratios should not be the only information used to identify risk. One has to account for other factors such as sector. For example a debt/equity ratio of 200% for a publicly regulated utility signals less risk than the same ratio for a luxury goods manufacturer. The staff at Morningstar follows a cult of ignorance where they do not see the need to understand statistical methods to help measure risk. In essence, they are throwing away information.

3) Not only does Morningstar ignore the discount rate used by the potential buyer, but they do not factor in the risk aversion of the potential buyer. If we have learned anything from the past decade, it is that risk aversion is changes frequently, and increases in risk aversion will drastically lower the market value of any risky asset.

4) The worst feature of Morningstar’s method is that they are not transparent. As I have mentioned, they do not tell us how they derive their growth rate assumptions and how they derive their uncertainty ratings. I suspect that the Morningstar analysts make them up on the fly.

I am disappointed by Morningstar’s analysts’ lack of intellectual interest in financial markets. They are simplistic “Warren Buffett wannabes.” Pat Dorsey’s “Little Books that Builds Wealth” says it all in the title. He believes that one can build wealth with little knowledge, little work, and little risk. All you have to do is find a firm with a “wide moat.” I now regret that I have follow Morningstar’s advice as often as I did. I am not more skeptical.

In the next posting, I will cover Morningstar’s methods for setting option strategies. Be forewarned that it is more incompetent than their stock valuation methods.