Ashley Redmond: Traders make a living off exploiting what a company is worth and what a company is trading at. And now with so many tools available DIY investors can attempt the same thing. One Morningstar data point that can really assist DIY investors is the fair value estimate. Here to discuss the fair value estimate and how to apply it appropriately is senior equity analyst Brian Colello.
Brian thanks for joining me.
Brian Colello: Thanks for having me.
Redmond: Brian what is the fair value estimate?
Colello: The fair value estimate is our estimate of what we think a company is worth at any given time. We come [to the conclusion] with a discounted cash flow analysis using the theory that you learned in finance class through a text book. We model out the company’s financial statements, both historically and what we project for the future. We discount those cash flows back by the firm's weighted average cost of capital and from there we try to estimate how much cash the company will generate. Usually over a 5 or 10 year span. Thereafter, based on the size of the company’s moat, how long we think the company will be able to sustain those cash flows. We'll then model out from years 5 or 10 thereafter and then that builds into our perpetuity to value the rest of the company.
Redmond: How should investors use the fair value estimate, by itself or in conjunction with something like the moat rating?
Colello: Well the moat rating is also very important. So, it's not just where a company is trading at any given time, but its sustainable competitive advantage and how long those cash flows will continue into the future based on that competitive advantage. We tend to think of stocks in the Warren Buffet, Benjamin Graham role of looking at good businesses at a fair price. So the moat helps identify good businesses and the fair value helps to identify the proper price. [Therefore], when the market is trading at a discount and the company looks cheap our fair value should be used to identify the adequate margin of safety in which to buy or sell. It’s also important to identify very good businesses that might be overvalued, so a lot of our fair values and our analysis isn’t just to highlight good stocks, but also to highlight good companies that are probably trading too high and where there isn’t much of a margin of safety and there is a little too much risk and not a good risk reward profile.
Redmond: What does fair value uncertainty mean? How should investors use that data point?
Colello: For every stock that we cover we have a fair value estimate, again that’s what we think the company is worth. The fair value uncertainty is essentially the margin of safety that we require before we would consider buying or selling a stock. So a company with a low uncertainty might be a company like a McDonalds or a Coca-Cola where we understand that the business is a more mature business with a stable set of cash flows versus a company like Netflix or Facebook where a lot of the investment thesis is based on the future and what the company can do five and 10 years down the line.
And so given the margin of safety if you have two stocks that are both worth $100 the low uncertainty rating we might consider buying at $80 and the very high uncertainty rating we might consider buying at $50. Again that’s based on the fundamentals of the business. Companies in cyclical industries might be very high, companies with an uncertain future, maybe those with high customer concentration. So if they are doing very well today but if they lose one key customer their revenues are chopped in half-- that would an example of what we see in terms of fair value uncertainty rating.
Redmond: Great, thanks so much Brian.
Colello: You are very welcome.
Redmond: To check out more videos on Morningstar methodology visit the funds page at Morningstar.ca.
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