How does the market determine the price of a stock? How do different analysts--including those here at Morningstar--come up with different fair value estimates for the same stock? These are important questions you need to understand if you want to invest in equities.
When an analyst says that a stock is worth x number of dollars, it's based on a formula that looks and sounds a lot more complicated than it really is, called a discounted cash flow model. What that essentially means is that we give a value today to what we believe will be all the profits that a company will generate in the future. Stock prices are always forward-looking, so a company's past results really don't matter that much. That's why even companies that have never turned a profit can have a high stock price, if investors believe that it will become very profitable in the future. The car maker Tesla is an extreme example of that.
Of course not every investor, analyst or fund manager agrees on what a particular company's future profits will look like. Predicting the future always means making assumptions, and that's often more art than science. It also relies on what's known as the discount rate, which reflects the time-value of money, or the fact that a dollar tomorrow is worth less than a dollar today.
The price you see quoted on the market for a stock is the price of the last transaction that was done on that stock, and it usually reflects a consensus of what most investors think it's worth. But an analyst can have assumptions that are different from the crowd, and that's where you can see fair value estimates that differ significantly from the stock price.
When Morningstar analysts think a stock is worth more than its current price, they give it a rating of four or five stars, but when its price is higher than its fair value, it's rated one or two stars.
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