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Morningstar.com
How Fair Value and Target Price Differ
Friday July 11, 7:00 am ET
By Debbie S. Wang


Dear Analyst,
Morningstar cites a fair market value for stocks. Is it reasonable to use this value as a target price for purchasing stocks and a selling price later when this value is reached?

A.G.

Readers often ask us how to use the fair value estimates we generate for the stocks we cover. It's a good question that deserves further explanation, especially because the fair value estimate is one cornerstone in the Morningstar investment approach, and it can be easily confused with the "target price" that Wall Street brokerage houses (also known as the "sell-side") often issue in their research reports.

A Subtle, but Important Difference
There is a key difference between the two prices: The Morningstar fair value is based on how much we believe the stock is worth, while a target price estimates how much other investors are willing to pay for the stock. This divergence emerges because we at Morningstar tend to assess stocks differently than Wall Street evaluates them.

Morningstar's fair value estimates aren't meant to be automatic buy or sell indicators. To determine reasonable buy and sell prices, we look at a stock's margin of safety. We like to buy when a stock's fair value estimate is considerably more than its market price. This is important because buying when the stock is trading at a discount protects the investor just in case the fair value estimate is too optimistic. On the other hand, when the market price has climbed far above the fair value estimate, this may be an indication that the stock is overvalued and potentially vulnerable to any hiccups that might come along. (For more on the margin of safety, see "Why You Need a Margin of Safety" by David Kathman.)

A Closer Look at Fair Value Estimates and Target
To derive the fair value estimates, we use our proprietary discounted cash-flow (DCF) model. This model assumes that the stock's value is equal to the total of the free cash flows the company is expected to generate in the future, discounted back to the present. So, the first step is to project how much cash a firm is likely to produce over a number of years, and subtract the amount needed for capital improvements and increases in working capital to keep the business growing. Whatever profits are left over belong to the shareholders. The second step is to discount those profits to understand how much they are worth today.

As with any DCF model, the ending value is highly sensitive to the analyst's projections of future top- and bottom-line growth. In addition, the cost of capital, which is determined by the firm's capital structure and its riskiness, is another influential factor in the fair value estimate. (For more discussion of the nuts and bolts of Morningstar's DCF model, please see David Kathman's article "How Morningstar Values Stocks".)

In contrast, target prices are usually formulated by taking an earnings estimate and then applying a multiple, most typically a price-to-earnings (P/E) ratio. In theory, the P/E ratio shows how much investors are willing to pay for a firm's earnings. For example, Boston Scientific's (NYSEBSXNews) shares recently traded at $62, compared with earnings over the last 12 months of $1.10 per share. This translates into a P/E of 56. In other words, investors are willing to pay $56 for every $1 of the firm's earnings.

To arrive at a target price for the future, sell-side analysts often take their earnings projections and multiply them by a P/E ratio that's appropriate for the industry, or reasonable by the company's historical standards. For instance, Boston Scientific's consensus earnings estimate for 2003 is $1.24. If we multiply by the P/E of 56, then we end up with a target price of $69.

Key Distinctions
There are several key differences worth noting. Morningstar's approach emphasizes cash flows, while price targets focus on earnings estimates. Both are measures of profitability, and both depend, to a great degree, on the analyst's projections of future performance. However, a company's management often has more discretion over how to report earnings, which can lead to distortions or accounting sleight of hand. Cash flows, on the other hand, are less vulnerable to manipulation.

Another important distinction is that Morningstar analysts typically have a longer time frame in mind when thinking about a company's prospects and how much profit it can generate--sometimes 10, 15, or even 20 years into the future. As a result, we are not particularly concerned with earnings in the next few quarters. For example, if McDonald's (NYSEMCDNews) experienced a near-term dip in earnings due to unusual weather conditions, we wouldn't be too worried and it likely wouldn't have any effect on our fair value estimate.

On the other hand, target prices from the sell-side analysts most often apply to a six- to 12-month time period. Because of this shorter window, sell-side models focus on the company's ability to meet short-term forecasts for the next quarter and year.

Worth vs. Price
Finally, keep in mind that what something is worth is not always the same as what someone's willing to pay for it. Just think about the last time you bought a pair of shoes on sale, and felt like you'd found a bargain because you paid less than you felt the shoes were worth. Or, conversely, the last time you went out for a meal and felt it wasn't worth what you'd paid. Our fair values are meant to provide an estimate of what the stock is worth, irrespective of what investors are willing to pay for it.

For instance, General Dynamics (NYSEGDNews) currently sports a fair value estimate of $100 per share, but sell-side target prices range from $62 to $73. Nicolas Owens, our aerospace and defense analyst, explains that this discrepancy springs from his longer-run outlook that assumes the Gulfstream unit, currently in a slump due to an anemic economy, is well-positioned to take advantage of an eventual upswing in demand for private jets (though this may not happen for several years). Sell-side analysts, with a shorter-run time frame, consider the lagging Gulfstream business a handicap to the company's near-term prospects, and their lower price targets reflect this perspective.

In a different example, we've estimated Boston Scientific's fair value at $54 per share, assuming that the firm captures 45% of the drug-coated stent market once it launches this anticipated blockbuster product in 2004. However, because the firm hasn't yet lined up another outsized home-run product and additional competitors are likely to enter the market by 2006, we have projected lower sales growth by that time. Sell-side target prices, in the range of $68 to $80, take into account the firm's expected stellar performance through 2004 without much consideration for what happens next.