“Investing in stocks with unpredictable cash flows when they’re trading at nosebleed valuations is a recipe for failure,” Susan Dziubinski, director of content for Morningstar.com, wrote in a recent blog post. “These are stocks to avoid.”
Dziubinski had in mind stocks with high or very high fair value uncertainty ratings that are trading at least double Morningstar’s fair value estimates.
The uncertainty rating, she noted, represents the predictability of a company’s future cash flows and, therefore, researchers’ level of certainty in Morningstar’s fair value estimate of that company.
“We value a company based on a detailed projection of its future cash flows, and discount those flows back to today’s dollars using a proprietary cash flow model,” she wrote.
The uncertainty rating captures a range of a company’s likely potential intrinsic values based on the characteristics of the business underlying the stock — such things as operating and financial leverage, sales sensitivity to the economy and product concentration.
If the range of potential intrinsic values is narrow, the company earns a low uncertainty rating. If the range is great, it earns a high uncertainty rating.
Dziubinski acknowledged that an argument could be made that in the case of a high-uncertainty stock, one could put aside valuation and instead focus on something else — growth prospects, for example.
“Given the lack of cash flow predictability, we could be underestimating the value of these names,” she said. “However, we could be overestimating their value, too.”
That is why Morningstar errs on the side of conservatism, she said.
“We suggest that investors avoid richly priced, high-uncertainty names. If one is truly tempted to take on the uncertainty, we’d recommend doing so with only a significant margin of safety — even if that fair value is, in itself, uncertain.”
See the gallery for 12 stocks Morningstar researchers consider extremely overvalued, and carry a lot of uncertainty as well. The moat ratings represent a company’s sustainable competitive advantage.