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Moats Matter: Valuation

- By Robert Abbott

Like all good value investors, the analysts at Morningstar (MORN) have an intense interest in the valuation of companies. In their case, it is also integrally connected with economic moats (or lack thereof). That's the focus of chapter six of "Why Moats Matter: The Morningstar Approach to Stock Investing."

Value, according to Joel Bloomer, Matt Coffina and Gareth James--all members of Morningstar's Moat Committee and contributors to its valuation methodology--refers to intrinsic or fair value, not share price. These three contributors, along with lead authors Heather Brilliant and Elizabeth Collins, recognized that markets go too high and too low in the short and medium terms.

Intrinsic value is defined as the present value of excess cash produced during an asset's or company's remaining life. Since investors expect a return on their capital, there is a discount rate, and so this approach is also known discounted cash flow analysis, or DCF.

The Morningstar approach aims to find risk-adjusted returns that are higher than the cost of capital. Thus, they use earnings before interest as their numerator (or return), while the denominator is based on invested capital. This allows them to take out the benefits of debt.

The authors also made the point that the cost of capital must be assessed. Their weighted average cost of capital includes both debt and equity and is used as the discount rate in their DCF models. This is what a DCF model looks like at GuruFocus, in this case for Patterson Companies (PDCO), a medical supplies company:

Patterson Companies DCF

In building their models, the Morningstar team divided the forecast period into three stages, compared with the two stages of traditional models:

  • Stage 1: Known as the "explicit forecast period," this is the detailed cash flow period.
  • Stage 2: They assume excess returns are being eroded by competition.
  • Stage 3: All excess returns have been eliminated and now return on new invested capital (ROINC) equals WACC.

How quickly the excess returns are exhausted depends on the width of the moat. No-moat companies will lose their competitive advantage quickly in the second stage, while narrow-moat companies are expected to enjoy excess returns for at least a decade and wide-moat companies should enjoy a competitive advantage for at least 20 years.

This graph from the book shows the typical life cycle of a Morningstar discounted cash flow:

Morningstar DCF profile

To show how they calculated the elements in a DCF, the authors used Patterson as an example, a company that had a wide moat when the book was published in 2014. From the balance sheets for 2012 and 2013, they arrived at a value for invested capital. They then tweaked the value by assuming its cash and equivalents were essential for operations, and everything else (goodwill, long-term assets and liabilities and deferred taxes) was removed.

EBI was calculated by adding net income and tax-affected interest expenses (presumably, taxes related to operations). Thus:

  • ROIC = EBI / IC
  • ROIC = $234 / $1,443 = 16.2%

Next, they calculated the weighted average cost of capital by adding shareholders' equity ($1.395 billion) and debt ($725 million) for a total of $2.129 billion.

Turning to the costs of debt and equity, the firm first established the borrowing costs with interest data from the financial statements (4.6%). For the cost of equity, Morningstar used a variation of the capital asset pricing model (CAPM), arriving at 10% (which is commonly used because it also reflects market risk).

When all the pieces were put together, they arrived at this formula:

WACC weighted average cost of capital formula

At 16.2%, the ROIC for Patterson was higher than the WACC of 7.6%, so there was an excess return of capital, signalling the possibility the company had a moat.

Moving on to the cash flow calculation itself, Morningstar made more tweaks; one of the most important was to ensure that "terminal value" was based on "normal" or "mid-cycle" earnings/cash flow. They converted EBI into cash flow by subtracting net new investments, and made a distinction between free cash flow to the firm (to shareholders and bondholders) and free cash flow to equity (what is available to shareholders after creditor obligations have been satisfied). The former, free cash flow to the firm, is what Morningstar uses.

Another part of their DCF strategy is to make forecasts at a more granular level. That is, with line items from the financial statements. They also add:

  • Competitive position.
  • The state of the industry.
  • Management strategy and executional skills.
  • Customer and supplier bargaining power.
  • Outside factors such as the course of the economy, technological developments, demographic trends, regulation and social trends.

The stronger a company is on each of these line items, the stronger its expected moat. Logically, the stronger the moat, the stronger the level of free cash flow in relation to earnings.

Because of the uncertainty of the future, the authors emphasized the use of scenarios to establish a range of possible outcomes. After analysis, there is a Bear case, a fair value case and a bull case.

Despite all the stages and steps, there is, and must be, an element of uncertainty in any DCF analysis; as the authors' said, "it's an imprecise science, which brings us to another key piece of our methodology that we haven't discussed much yet--our confidence in each fair value estimate, codified in our valuation Uncertainty Ratings."

Analysts ask themselves about the probability they might be wrong when assessing intrinsic value, and answers go into one of "five buckets of uncertainty":

  • Low
  • Medium
  • High
  • Very high
  • Extreme

As the uncertainty gets higher, bucket by bucket, the greater the margin of safety required. The authors wrote, "as valuation uncertainty increases, so does the prudent margin of safety."

In assessing risks, the system involves determining if they are "systematic" or "nonsystematic." In the case of nonsystematic, it means company-specific risks. Systematic risk refers to sensitivity to the economy; how much does a company's intrinsic value change with any given change in gross domestic product? It is measured as "beta".

Having now covered fair value estimates and uncertainty ratings, Morningstar shows how they fit into its star ratings for individual stocks:

Morningstar rating process

Finally, though we may not have any interest in the firm's rating results, its processes should help all value investors develop better valuations and account more thoroughly for uncertainty. Additionally, improvements in these areas should help us draw up more accurate discounted cash flow estimates for an always messy future.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.