Introducing Changes to Morningstar's Equity Valuation Methodology
We've enhanced our methodology, which could result in modest fair value changes.
Our DCF model includes three stages of analysis. The first stage includes our forecasts for the next five to 10 years. In the first stage, analysts make explicit forecasts for all of a company's important financial statement items, such as revenue, operating costs, capital expenditures, and investments in working capital.
We discount future cash flows using the weighted average cost of capital, which incorporates the cost of debt, equity, and preferred capital. The discount rate is a key assumption in any DCF model. While the cost of debt and preferred stock can be observed in the marketplace, the cost of equity presents a significant challenge. In the past, analysts have been allowed significant discretion in choosing a cost of equity (COE), but we have formalized our approach in the latest model.
The final significant change to our methodology involves the time value of money. Discounted cash flow valuation produces an estimate of a company's worth as of a specific point in time. That value tends to increase over time as cash flows are earned and future cash flows are discounted less.