By Torsten Hunke, chief operating officer, VanEck Europe.

VanEck: A wide moat is only half the battle.

Determining the value of an asset is a key part of any investment decision, indeed the most important part for many investors. Suppose you want to purchase a property. You are interested in a building that, under normal circumstances, would be worth $500,000. However, if this property has an asking price of $650,000, you would probably shy away from buying it. And rightly so, as several years will likely need to pass before market prices approach this asking price. And by then you would have lost real purchasing power thanks to inflation.

In the case of moat investing, the valuation of shares with a wide moat rating also plays a major role. A reminder: economic moats are long-term competitive advantages that companies can use to defend their market share from competition.  Morningstar’s equity research department identifies such companies with long-term competitive advantages and ranks them by the amount of time they are expected to sustain their advantages. Companies who are expected to sustain their competitive advantages for at least 20 years, receive a Morningstar Economic Moat rating of “wide”. However, investors should not just look at the moat or the quality of a company, but also at its share price. After all, anyone looking to make a profit on a share must acquire it at the most attractive price possible. The fair (market) price serves as a guide here.

In order to determine the fair value price of a share, Morningstar has developed a multi-stage analysis process based on the underlying assumption that each company has a fair market price. With this approach the equity research company department is able to project the future cash flows of a company:

Stage 1: Explicit forecast

When analysing a company, Morningstar first prepares full financial statement forecasts, including estimates for revenue, profit margins, tax rates, changes in working capital accounts and capital spending for the next five to ten years. Based on these figures, it then calculates earnings before interest after taxes (EBI) and the net new investment (NNI) in order to then derive the annual free cash flow forecast.

Stage 2: Fade

Here Morningstar calculates how long it will take a company’s return on new invested capital to be at the same level as its cost of capital. In contrast to the first stage, in which the financial statement projections are estimated using an explicit model, Morningstar forecasts the future cash flow here using a different formula, i.e. the time a company needs for the two performance indicators to equal each other depends on the width of its moat. In the case of companies with a wide moat, it may take 10 to 15 years. During this period, cash flows are forecast on the basis of four assumptions:

• An average growth rate for the EBI during the reporting period
• A normalised investment rate
• Average return on new invested capital (RONIC)
• The number of years until perpetuity, when excess returns cease

Stage 3: Perpetuity

As soon as the marginal ROIC of a company equals its cost of capital, Morningstar calculates a continuing value based on a standard perpetuity formula. At perpetuity, any growth or decline in revenue results in an NPV=0 proposition. Stated differently: In the perpetuity period, it is assumed that growth, decline or investment in the business neither creates nor destroys value, and that any new investment provides a return in line with the estimated weighted average cost of capital (WACC).

Discount rates

As every euro earned in the present is worth more than a euro earned in the future, Morningstar discounts its projections of cash flows in all three stages in order to calculate the present value of expected future cash flows. The free cash flow of a company is calculated in order to determine whether a company would be able to pay a return to capital providers. Morningstar accordingly discounts the forecasts of future cash flows by the WACC.

While many investors get caught up in daily stock price movements, the independent investment research company, Morningstar, prefers to think about valuation in the same way as you would about a real asset. Central to Morningstar’s analysis is the Fair Value Estimate, which is based on the estimation of the intrinsic value of a stock. The intrinsic value of a company is determined by the future cash flows it may generate. Due to market dynamics, the fair value may deviate from the current valuation, but this is only for a limited period.

Rational buyers maximize their returns

In the first part of this blog post we explained how Morningstar determines the fair value of a stock. We gave an example of a real estate purchase, where we showed why a rational buyer will not accept any purchase price higher than the real value of a property. In this instance, a real estate buyer wants to make a purchase not only at its fair value, but as much below its fair value as possible in order to maximize their returns. Even if the purchase price equals the real value of the property, future returns would depend on the future development of the market price. If for example the buyer were to persuade the seller into selling at a lower price, he or she would immediately profit from the discrepancy between the purchase price and market price, as well as the future development of the latter.

Stocks with highest difference to fair value

This buying strategy also works on the stock markets. However, while investors can’t negotiate the price of a stock, they can watch out for discrepancies between the market price and the fair value that various market dynamics can cause. For example, ExpressScripts Holding Company, an American manufacturer of pharmaceutical products, holds a Morningstar Economic Moat rating of ‘Wide’ as the company benefits from high cost advantages and switching costs. The stock currently has the highest difference to its Fair Value in the Morningstar Wide Moat Focus Index, which makes it the most favourably priced index component in relative terms. The quotient of its fair value and market valuation as of 16 June 2017 was 0.71. In other words, the stock traded 29 percent below Morningstar’s Fair Value Estimate at this point. But because the intrinsic value of the stock is expected to be higher, the difference between fair value and market valuation is likely to even out over time – giving the stock sizable upside potential.

Quality stocks with attractive valuations

In the Morningstar Wide Moat Focus Index, the market price to fair value ratios ranged from 0.71 to 0.98 at the time of the most recent index review. The reason why the index does not include a stock with a ratio of 1 or higher is easily explained: If the ratio were 1 or more, the market price of a share would be higher than its fair value. Even in case of a quality company with a wide Morningstar Economic Moat, its future cash flow potential would already be priced in by the markets, thus limiting its upside potential.  The secret to the impressive track record of the Morningstar Wide Moat Focus Index lies in exactly this combination of quality wide moat stocks and attractive valuations.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)