Morningstar Guide to Share Investing

Introduction

As a young child growing up, I was lucky to receive each birthday a small number of shares from my parents. They would choose companies that sold products to which I could relate and would then use my investments to teach me what it really meant to be a share investor.

Whenever we walked by the Chase Manhattan bank headquarters in New York City, for instance, I would be told that I owned part of the building. Similarly, if I bought a pair of Nike shoes I would subsequently be informed that a small part of what I had paid for them would come back to me in the form of a dividend. Over time, I understood what it meant to be a shareholder. These childhood lessons had a profound impact on how I’ve viewed investing ever since.

There is a gulf between knowing the definition of something and having a deep understanding of a concept. So it goes with investing. Consider a share, for instance. Is it merely a virtual piece of paper whose price fluctuates according to a president’s tweets, or the whims of corporate chieftains and self-interested financial institutions? Or does it represent a stake in the future cash flows generated by a business selling goods and services? And when you buy a share, what are you actually putting your money towards? Are you placing a bet or making an investment?

At Morningstar we passionately believe that making better investment decisions can transform lives. Central to this belief is clearly defining what you are buying when you purchase a share. It isn’t a virtual piece of paper that is traded for short-term profits. Buying a share means becoming an owner of a business.

We believe that adopting an ownership mentality drives behaviour that will lead to better investment returns. An ownership mentality means thinking long term and ignoring market volatility. It means focusing on the underlying reasons that allow a business to generate future cash flows instead of playing the short-term earnings estimate beat / miss / match game.

We’ve designed this guide for investors who seek to use the share market to build long-term financial security. We hope you find it helpful.

Happy investing,

Mark LaMonica

What are you buying when you purchase a share?

As the name suggests, purchasing a share of a company makes you a partial owner of the business. That means that you own a portion of everything that the company has or does. This may take the form of tangible assets such as factories, equipment, real estate, cash and securities. Or intangible assets such as patents, trademarks, copyrights and brand names. A well as assets, buying a share also means that you “own” a portion of any liabilities a company may have. This may take the form of debt and other obligations a company has, including payments to suppliers, wages and taxes. The difference between the company’s assets and liabilities is called the “book value”. The “book value per share” represents what you are buying when you purchase a share.

Sometimes, albeit rarely, you can purchase a share for less than the book value per share. That means you are buying a portion of a company for less than it could raise in cash if all the assets were sold and all the debts and obligations were repaid. We will discuss different ways to value companies later in the guide. For now, it is important to note that the “price to book value”—in short, what something is priced at as opposed to what it’s worth—of the ASX is 2.17 as of 15 July 2019. The fact that investors are willing to pay $2.17 for something that is worth $1 provides a clue to what investors are really buying when they purchase shares.

What investors are buying is the future ability to generate cash. After all, a company is simply an organisational structure that is designed to take a group of people and a collection of assets and generate cash in perpetuity. An investor is not buying Facebook on 15 July 2019 to become an owner of a company that has a price that is 6.73 times book value. Investors are buying Facebook based on two key characteristics: the network effect that is generated by the social network’s roughly 2.30 billion active users (on their namesake platform alone); and the intangible asset it boasts in the form of its vast collection of data. The investment case hinges on the promise that Facebook will be able to generate cash by selling advertising based on its traffic and data.

Putting your faith in the idea that with a massive user base and collection of data Facebook will continue to be a cash-generating social network that doubles as an advertising platform is anything but a short-term bet. An investor with an owner’s mentality must be confident in the long-term hypothesis that Facebook will remain the clear-cut social media leader and will not be derailed by government regulation or a large-scale defection of users. Whatever your position may be on Facebook’s prospects it is unlikely that a weaker-than-expected earnings release or a negative news story is going to change it.

Owning a share of a company that is traded on the stock market is no different to setting up your own business. Small business owners don’t cavalierly sell their otherwise successful business because of one poor month of sales. They certainly wouldn’t sell their business if it grew significantly but slightly below the expectations. An owner’s mentality means taking a long-term view. Unfortunately, however, many things can conspire against even the most well informed investor.

What is the stock market?

Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years—Warren Buffett

Distinguishing between what you buy and where you buy it is crucial. Since buying a share makes you a partial owner of a company, the stock market is simply a means to purchase and sell shares. It is a marketplace that connects buyers and sellers. A key benefit of stock investing is liquidity. An asset is considered liquid if you can buy and sell it quickly without any meaningful drop in its price. This is attractive for investors because they can quickly convert a share into cash. To facilitate this, it is necessary to have constant price discovery. In other words, both buyers and sellers need to know the price of shares in order to make both sides comfortable enough to transact. That is the role of the stock market and market participants.

Liquidity is crucial when it comes to distinguishing between investing in a company that trades on the stock market and buying an investment property, or a small business. Imagine a world where you constantly knew exactly what someone would pay for your house and you had the ability to sell it to them in minutes for an insignificant commission. It would not be long before this constant flow of information would start to change your behaviour. The ability to check the price doesn’t mean you would always do it. But you would probably check when there were large price swings, possibly caused in part by your friends, family and the media weighing in. The constant price discovery and the ease of transacting would amplify the fear and greed of market participants. And fear and greed cause people to act when it is generally in their best interest to do nothing. Constantly buying and selling investment properties or small businesses would be a mistake. Yet many people think “playing” the market through continual trading is an effective approach for building long-term wealth.

The fact that you can do something doesn’t mean it is a good idea. Maybe you are a savvy trader who can enter and exit positions at just the right time. Chances are you are not. At Morningstar we advocate a long-term investing approach. Taking a patient, long-term view helps us ride out the market’s ups and downs and seize on the opportunities when they arise. We know that investors often overemphasise the importance of recent events, rushing into hot stocks when they’re overpriced and fleeing from market downturns. We fight this common error by focusing on long-term lessons and long-term performance.

How do you identify great companies to buy?

If you want to be a successful long-term investor it doesn’t get much easier than simply buying shares in great businesses and holding them for a long time. So, what is a great business? At Morningstar we believe a great business is one that has a long-term competitive advantage, which allows it to fend off competitors while investing capital at a high rate of return. The long-term competitive advantage of a business is called an economic moat. Just as moats were dug around medieval castles to keep enemies at bay, economic moats protect the high returns on capital enjoyed by the world’s best companies. A company with an economic moat is quite rare because any time a profitable product or service is developed other firms respond by trying to produce a similar version, or even improving on the original version. Some companies are able to withstand the relentless competition of the marketplace and these are the wealth-compounding machines that an investor wants to find and own.

We believe there are five major sources of competitive advantage, or economic moat:

1. Intangible assets: These can include brands, patents, or government licenses that explicitly keep competitors at bay. This can be seen in pharmaceutical companies with patent protection or with consumer brands that have long-standing and well-regarded brands.
2. Cost advantage: Firms that can provide goods and services at lower costs have significant advantages over rivals as they can either undercut their rivals on price or sell at the same price and earn a higher profit margin. Generally, moats based on cost advantage are due to economies of scale. Economies of scale is defined as the cost advantages that companies obtain due to the scale of their operations with the cost to produce a product or service going down as output increases.
3. Switching costs: Switching costs refer the inconveniences or expenses associated with a customer switching from one product to another. Banks can be good examples as it is time-consuming to switch bank accounts once you have set up direct deposits and payments.
4. Network effect: The network effect occurs when the value of a particular good or service increases as more people use the good or service. Social media sites are perhaps the best example as a low number of members provides less of a benefit to a user than a high number of members.
5. Efficient scale: Efficient scale applies to companies that serve limited markets where there are a small number of competitors. Potential competitors are discouraged from entering the market based on the small opportunity. An example can be a pharmaceutical company that produces drugs for diseases that only affect small patient populations.

Morningstar analysts assign a moat rating to select companies in our coverage universe. You can find the moat rating in the Morningstar Analysis section of our quote pages and a full description of the rationale for assigning a moat rating in the analyst notes section.

Valuation: value versus price

“The stock market is filled with individuals who know the price of everything, but the value of nothing.”—Phillip Fisher

It is easy to figure out the price of almost anything. A central tenet of the modern economy is price discoverability. In simple terms that means that in order to encourage commerce the price of goods and services must be widely known. This tenet also applies to liquid financial assets such as stocks or bonds. A quick trip to the internet is all it takes to find out the price of any liquid security. That is the magic of market liquidity. We are always able to find the price of liquid assets because they are constantly changing hands and thus always fluctuating. This fluctuation causes many investors a good deal of angst and causes many people to forget that an equity is not simply a piece of paper being traded but ownership of the underlying business.

While much is made of the short-term noise that drives day-to-day price fluctuations, in the long term it is the performance and value of the underlying business that will influence the stock price. As, Ben Graham, the so-called father of value investing once famously said: “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” Whereas the hypothetical voting machine deals with expectations, the weighing machine deals with the actual economic benefits provided to the owners. Simply put, Graham is saying the price and the value of an equity may deviate significantly over the short term but eventually they will intersect. That is why we are so focused on intrinsic value at Morningstar and why we include our valuation estimate within each of our research reports.

How do you value a stock?

There are countless ways to value a stock. At Morningstar we have a very specific approach which we will go through in detail in the next section. However, we want to cover the other approaches that investors take.

Comparative analysis

Rather than trying to calculate the intrinsic value of a share, a comparative analysis simply compares the price multiple of a stock to something else. That “something else” could be a comparison of the current or historical multiple of other companies. This could be a wide-ranging comparison that looks at the market as a whole or could be a more specific comparison to similar companies that compete in the same industries.

Price-based ratios

Advantages

• The primary upside to these ratios is that they are simple to calculate and provide an easy comparison between different companies or markets.
• They can be a jumping-off point for a more rigorous analysis. The number of publicly traded companies can be overwhelming for any investor and ratios can be a quick way to filter the investment universe.

Disadvantages

• They are a simplistic way to summarise the valuation of complex companies in a single ratio. A P/E ratio for example doesn’t tell you how fast earnings are growing, the risks associated with that earnings stream, the quality of the company or a myriad of other factors that may or may not make a company a good investment.
• Many of these ratios are based on financial statements that are prepared using accounting standards. Some investors argue that accounting standards do not accurately reflect the performance of companies. To fully explore this topic we would have to write a separate guide, but we thought it was at least worth noting.

Popular price based ratios

Price/Earnings

Price/earnings for a stock is the ratio of the company's most recent month-end share price to the company's earnings per share (EPS).

Benefits

The P/E ratio relates the price of the stock to the per-share earnings of the company. A high P/E generally indicates that the market will pay more to obtain the company because it has confidence in the company's ability to increase its earnings. Conversely, a low P/E indicates that the market has less confidence that the company's earnings will increase, and therefore will not pay as much for its stock.

Origin

Morningstar generates this figure in-house based on stock statistics from our internal equities databases. For stocks, this figure is calculated monthly.

Price/Book

Price/book for a stock is the ratio of the company's most recent month-end share price to the company's estimated book value per share (BPS) for the current fiscal year. Book value is the total assets of a company, less total liabilities.

Benefits

The price/book ratio can tell investors approximately how much they're paying for a company's tangible assets, based on accounting valuations. Assets are usually valued on a company's books at the historical acquisition cost, less any depreciation. The book value may be different than the current market value for those assets and the stock price may reflect that. Also, book value often excludes intangible assets, such as patents, trademarks, and brand names; therefore, companies with a lot of intangible assets often have larger price/book ratios. Value investors frequently look for companies or portfolios that have low price/book ratios.

Origin

Morningstar generates this figure in-house based on stock statistics from our internal equities databases. For stocks, this figure is calculated monthly

Price/Sales

Price/sales for a stock is the ratio of the company's most recent month-end share price to the company's sales per share (SPS).

Benefits

Price/sales is a valuation measure that indicates how much an investor is paying for a revenue stream. Because revenue measures are less subject to accounting standards than many financial statement figures, this valuation measure is more useful than many others in comparing stocks from different countries. Still, without information about the profit margins of the underlying stocks, this statistic is of limited use. This is less of a problem for specialty portfolios, since margins across specific industries are more consistent.

Origin

Morningstar generates this figure in-house based on stock statistics from our internal equities databases. For stocks, this figure is calculated monthly. For funds and portfolios, Morningstar updates this figure upon receipt of the most-recent portfolio holdings from the asset manager.

Price/Cash Flow—Projected

Price/cash flow (projected) for a stock is the ratio of the company's most recent month-end share price to the company's estimated cash flow per share (CPS) for the current fiscal year. Cash flow measures the ability of a business to generate cash and it acts as a gauge of liquidity and solvency. Morningstar calculates internal estimates for the current year CPS based on the most recently reported CPS and average historical cash flow growth rates. Price/cash flow (projected) is one of the five value factors used to calculate the Morningstar Style Box. For portfolios, this data point is calculated by taking an asset-weighted average of the cash flow yields (C/P) of all the stocks in the portfolio and then taking the reciprocal of the result.

Benefit

The price/cash flow ratio can tell investors approximately how much they're paying for a dollar of cash flow. Because of differences in accounting standards across the globe, price/earnings ratios are not always reasonable for comparing companies from different countries. Price/Cash Flow attempts to provide a consistent standard of comparison.

Origin

Morningstar generates this figure in-house based on stock statistics from our internal equities databases. For stocks, this figure is calculated monthly. For funds and portfolios, Morningstar updates this figure upon receipt of the most-recent portfolio holdings from the asset manager.

Dividend Yield—Projected

Dividend yield (projected) for a stock is the percentage of its stock price that a company is projected to pay out as dividends. It is calculated by dividing estimated annual dividends per share (DPS) for the current fiscal year by the company's most recent month-end stock price. Morningstar calculates internal estimates for the current year DPS based on the most recently reported DPS and average historical dividend growth rates. This is one of the five value factors used to calculate the Morningstar Style Box. For portfolios, this data point is calculated by taking an asset-weighted average of the dividend yields of all the stocks in the portfolio.

Benefit

When companies make a profit, they can either share that profit with shareholders in the form of a dividend, or they can reinvest that money into the business. High dividend yields are often indicative of value stocks. Growth stocks tend to reinvest profits back into the company and therefore have low or no dividends.

Origin

Morningstar generates this figure in-house based on stock statistics from our internal equities databases. For stocks, this figure is calculated monthly. For funds and portfolios, Morningstar updates this figure upon receipt of the most-recent portfolio holdings from the asset manager.

There are two places to find price based financial ratios on Morningstar Investor. The first is on the summary of the quote page for each of the 45,000 companies within our database. We provide both the trailing Price/Sales, Price/Earnings and Price/Book value along with the forward (estimated) Price/Earnings and Dividend Yield.

The valuation section of the quote page provides a comparison to historical figures and the overall market. A comparison to historical levels shows how the relative valuation of a company has changed over time and may indicate that a company has become over or under valued. What the ratio alone does not tell you is if the change in valuation was warranted. Only additional research can answer that question. This is also true when comparing valuation levels of a company to the overall market. Discrepancies may indicate a company is over or under valued but also can be warranted by company fundamentals.

How does Morningstar value a stock?

At Morningstar we believe in fundamental equity analysis. A fundamental research approach means gaining a deep understanding of each investment. At its core, a fundamental investing approach means focusing on the future earnings of an investment and not its prospective price change. Our focus on fundamental research means we don’t fall victim to convincing stories to support the merits of an investment.

We believe that there is both an art and a science to valuing stocks. An art in deeply understanding the company, the product, the customers and the competitive landscape, and a science in being able to marry those understandings with the financial statements. The output from this analysis is a fair value estimate of the share. We don’t care what the stock market says the share is worth. We care what the underlying company is worth because we think in the long term that will be reflected in the share price. Ultimately, Morningstar analysts believe a company's intrinsic worth is linked to the future cash flows it can generate.

Uncovering a company's fair value

Forecasting is hard. But a good analyst who has spent years getting to know an industry well, can use informed assumptions and technical analysis to successfully predict a company's future revenue and growth prospects.

Morningstar analysts use a valuation method known as a discounted cash flow, or DCF. The key behind a DCF model is relatively simple: a stock's worth is equal to the present value of all its estimated future cash flows, minus an appropriate discount rate. It helps to walk through an example so we will explore how we calculated the fair value for The a2 Milk Company.

Step 1: Estimating future cash flows

Future cash flows refer to how much cash the analyst believes the company is going to generate in the future after spending the money necessary to keep the company growing at its current rate. Many variables go into estimating those cash flows, but among the most important are the company's future sales growth and future profit margins.

Predicting growth

Predicting a company's future revenue needs detective work. Beyond the company's top line revenue figures, analysts will consider a variety of additional factors including:

• customer base
• product quality
• industry trends,
• economic data, and
• a company's competitive advantages

For example, let's look at A2 Milk's historical revenue growth:

A2 Milk historical revenue growth

Looking at that strong revenue growth over the past five years, you might be tempted to think: wow, it's accelerating each year, 80 per cent might be next.
But this is unlikely to get you to the correct figure. The potential pitfalls of only looking at revenue is you don't know exactly what's driving that revenue, and it's hard to make an assumption when you don't know the component parts.

We break down A2's revenue, looking deeply into geography—where A2's product is consumed, where it's sold, the type of products each market consumes, gathers insights into the volume growth of infant formula, the price growth of the infant formula market, and movements in A2's market share. We can use these estimations to predict how much A2's revenue will grow, on average, for the next ten years.

Predicting profits margins

Determining a company's future operating profits also needs creative thought. For A2 Milk, historical EBIT margins– earnings before interest and tax—look great:

A2 Milk historical EBIT and margins

But just like revenue, investors have to be cautious about extrapolating the past into the future.

We need to dig deeper, looking to A2's competitors to determine the current margins for infant formula, and estimate how much larger margins can get.

Once an analyst estimates the cash flows they expect the company to generate in the future, they have to discount those future cash flows back to the present to account for the time value of money.

Step 2: Discounting cash flows

Once analysts estimate the future cash flows they anticipate a company to generate, they have to discount them back to the present day to account for the time value of money.

Why? Because a dollar tomorrow is worth less than a dollar today. If you have $100 today and you put it in a bank account, and it earned 2 per cent a year, you would have $102 dollars one year from now. In 2 years it will become $104.04; 3 years $106.12, and so on. But if we flip that, $122 dollars 10 years from now, is worth $100 dollars today, at a 2 per cent per annum interest rate.

Step 3: Determine a discount rate

So, how do analysts determine the discount rate? Morningstar analysts use a weighted average cost of capital, or WACC, to determine the rate at which to discount a company's future cash flows back to the present. A company's WAAC accounts for both the firm's cost of equity and its cost of debt.

The cost of debt is relatively straightforward: It's the interest rate a company must pay to borrow money, based on the current yield on any of the bonds the company has issued. Just as a person with an excellent credit rating can borrow from banks at lower rates than someone who has missed payments in the past, financially strong and stable companies can borrow at lower rates than riskier firms.

The cost of equity is a little more complicated, but Morningstar analysts have adopted a simplified methodology. For companies with a primary business is in Australia, they assign a cost of equity of 7.5 per cent, 9.0 per cent, 11.0 per cent, or 13.5 per cent depending on a company's level of systematic risk.

Let's go back to the A2 Milk (ASX: A2M) example we used in part one.

Morningstar analysts view the company as an average risk company and have estimated a 9 per cent cost of equity. Then, they added 1 per cent due to the company’s exposure to China upping risk. Currently A2 Milk has no debt, meaning there is no need to include a borrowing rate in the WACC calculation.

Step 4: Discount the projected free cash flows to the present

So now that we have our discount rate of 10 per cent, we can discount the projected free cash flows to the present. This is where the maths comes in.

Here's the basic formula for discounted cash flows:

For example, in 2018, Morningstar analysts have projected A2 Milk's free cash flow to be NZ$285,363 in 2019. Discounted:

A2 Milk free cash flow projections

But wait, that doesn't seem right…the stock is currently trading at almost $10. What are we missing?

Step 5: Calculate the terminal value and discount it to the present

The last piece of the puzzle is the terminal value—also known as the perpetuity value.

This step is necessary because companies exist much longer than 10 years, and analysts need to account for all the cash earned for all those years. However, he says it's not feasible to project a company's future cash flows out to infinity, year by year.

To solve this problem, we estimate’s a company's future cash flows for a certain period, and then estimate’s the value of all cash flows after that in one lump sum.

The equation looks a bit technical, but it’s really quite simple:

For A2 Milk:

Therefore, the present value of our Tv is:

Step 6: Final valuation

You've made it to the end. That wasn't easy. While discounted cash flow method is certainly a complicated way to value stocks, there are many benefits that come with the increased effort.

If you didn't understand certain aspects, don't worry, you don't need to. Morningstar analysts provide you with a final valuation—their fair value estimate—which does all the hard work for you.

To reach the final valuation, our team takes 10 years of free cash flow forecasts, discounted to today plus terminal value, discounted to today minus net debt and other adjustments divided by share count equals fair value estimate.

For A2 Milk:

As equity holders, any debt the company has would not belong to us. Therefore, need to remove that from the calculation.

Additionally, the model didn't include any cash or other holdings A2 has today—only that generated in the future. We remove debt, add cash, and add the firm’s holding in Synlait, another New Zealand stock.

From there, we divide the equity value by the number of shares outstanding, to get our fair value/share.

Resources to help you identify shares to purchase

Our equity analysts provide fundamental qualitative research on over 1500 global shares. Each share in our coverage universe receives three distinct ratings:

• An Equity star rating that provides a risk adjusted comparison of our fair value calculation with the current market price of the share
• A Moat rating that assesses the sustainable competitive advantage of the company
• A stewardship rating which assesses management’s ability to allocate resources to generate positive returns for shareholders

You can access our research by entering the company name or the ticker into the search bar located at the top left-hand corner of any page on our website.