Skip to Content
Stock Strategist

Searching for Value in the Stock Market

We look at the valuation discrepancies among different stock types.

Mentioned: , , , , , ,

Are stocks cheap or expensive? Today, more than usual, the answer depends on which stocks you're talking about.

Using a proprietary discounted cash-flow model, Morningstar analysts publish fair value estimates on about 500 stocks, which are mostly (but not entirely) large caps. Aggregating this data offers some useful insights. For instance, the average price/fair value ratio of all 500 stocks can give us a feel for the valuation of the stock market as a whole at any given time.

Not every fair value estimate is right, of course--that's why they're called estimates. (In fact, there is no one "right" fair value for a stock, as I explained in this recent article.) But taken together, our valuation estimates for individual securities can give a good idea of the valuation of the broader market. Our fair values will be too aggressive for some stocks, too conservative for others, but on average, they're about right.

By the same token, the average price/fair value ratio for a particular group of stocks, such as wide-moat stocks, low-risk stocks, speculative stocks, etc., can be useful, too. I've written about stock valuations several times this year, but I haven't done much work on differentiating the various stock types from one another. Maybe value stocks are cheap, while growth stocks are expensive? Or vice versa. Maybe speculative stocks are bargains, partially explaining why they're up so much this year? To find out, I did a little slicing and dicing of Morningstar's fair value estimates.

Here's what I discovered.

Four-Letter Stocks
Stocks with four-letter tickers (read: Nasdaq stocks) are wildly overvalued, according to our estimates of their future free cash flows. As of Nov. 7, the 93 Nasdaq stocks we cover had an average price/fair value ratio of--get ready--1.39. This means these stocks are, on average, 39% overvalued according to our estimates. (These stocks were undervalued by 25% in October 2002, according to our estimates, but have since run up 80%.)

Now, you might argue that our tech analysts are being too conservative--are just missing a nascent tech rebound--and therefore, they are undervaluing these stocks. But we have more than a dozen analysts who cover at least one Nasdaq stock each, and their fair values are calculated independently. It's hard for me to accept that a dozen analysts can all be too conservative at the same time, not just by a small margin, but by 39% on average. 

And only about half of the Nasdaq stocks we cover are considered "tech." In fact, we cover 52 Nasdaq-listed software, hardware, telecom, and biotech equities. The other 41 are non-tech stocks, such as  Paychex (PAYX),  Amazon.com (AMZN),  Biomet (BMET),  Costco Wholesale (COST),  JetBlue Airways  (JBLU), and  Northern Trust (NTRS), among others. So, if you want to contend that Nasdaq stocks are not overvalued, you'd have to argue that our tech analysts as well as our airline, retail, business-services, and banking analysts are all too conservative.

Risk Trumps Return
We rate the business risk of 128 stocks as "above average," and 28 of these are listed on the Nasdaq. These risky equities are overvalued by an average of 47%, according to our estimates. Since 100 out of these 128 are not on the Nasdaq, it seems that overvaluation is not confined to four-letter ticker symbols.

One way to look at the extent of overvaluation among risky stocks is to assume that over the next three to five years, their prices will revert to their fair values. Also assume that their fair values will rise each year at the same rate as their cost of equity; for high-risk stocks, that's about 12.5%, on average. Running those numbers, the expected three- to five-year return of our group of 128 high-risk stocks is in the range of -1.1% to +4.2% per year.

At best, that's about the same as a risk-free 10-year government bond. And that's assuming these stocks revert exactly to their fair values in three to five years, rather than shoot below their fair values into undervalued territory. If that happens, the three- to five-year return on high-risk stocks will almost certainly be negative.

Still want to buy that tech mutual fund that's up 100% this year?

Low-Risk Stocks
Low-risk stocks are about fairly valued right now, according to our estimates. Stocks labeled "low risk" under our system are selling at a price/fair value ratio of 1.00--right at fair value. There are 91 low-risk stocks in our coverage universe, large enough for the average value to be statistically significant. Again, these fair value estimates are calculated by multiple analysts working independently. Our analysts don't get together once a week and say, "This week, let's raise the fair values of all low-risk stocks." It just so happens that their fair value estimates are telling me that low-risk companies like  Harley-Davidson  (HDI),  Coca-Cola (KO), and  Wrigley (WWY) are fairly valued, on average.

Using the same assumptions as above to calculate the three- to five-year expected return on low-risk stocks, with a cost of equity of 9.25% (the average for this group), I came up with an expected return in the range of 9% to 9.5% per year. This is better than a money market fund, better than a government bond, and certainly better than a basket of high-risk stocks. But it's still not high enough for me to go out and buy low-risk stocks willy-nilly. I want a higher return than 9.5% per year.

Wide-Moat Stocks
The 98 stocks we rate as having wide economic moats are, on average, overvalued by about 4% right now, implying a three- to five-year expected return of 7.5% to 8.4% per year. Almost all of these are rated below-average or average risk.

By contrast, the 104 stocks we rate as having no moat are, on average, overvalued by 35%. This implies an expected three- to five-year return range of 1.3% to 5.5% per year. No-moat stocks, many of which are rated high risk, are simply not compelling buys right now.

Historical Data
These numbers mean more when placed in a historical context. We haven't always considered high-risk stocks wildly overvalued. For example, on Oct. 9, 2002--the nadir of the bear market--high-risk stocks were 27.5% undervalued, respectively, according to our estimates. This implies that the expected three- to five-year return on these stocks was 19.9% to 25.3%. They were due for a rebound.

High-risk stocks were also more than 15% undervalued in September 2001 and early March 2003. During all three of these periods, low-risk stocks were also undervalued, but not by as much as risky stocks. Whenever the average price/fair value ratio of high-risk stocks has fallen below that of low-risk stocks, the market has quickly rebounded.

Perhaps our price/fair value estimates are a good way to identify those rare times when stocks are "oversold" and investors are being too pessimistic.

A Stock-Picker's Market
Warren Buffett has said that he won't invest in a stock unless it can promise at least a 10% pretax annual return. I'm even stingier. (In reality, I think he is, too, especially when he buys a minority interest in a publicly traded company). I look for a 15% five-year expected annual return before I'll invest. In other words, I want to double my money every five years.

There are 23 stocks in our universe that, based on the discrepancies between their Nov. 7 closing prices and our fair value estimates, promise a 15% or greater return per year over the next five years.

But I don't want to buy all 23 of them. I have more confidence in our fair value estimates on wide-moat stocks because these companies are more predictable. If I'm going to buy only a few of them, rather than a large basket, I want to be sure my fair value estimates on those few are accurate. A high degree of confidence on individual fair value estimates is possible only if you're valuing mature, stable companies--and wide-moat companies are typically of this sort. If you're going to put all your eggs in one basket, you'd better be sure the basket doesn't have a large hole in it.

There are only four wide-moat stocks with an expected return higher than 15% per year over the next five years:

 Wide-Moat Stocks with High Expected Returns
Risk
Rating
Fair
Value ($)
Current
Price ($)
Morningstar
Rating

5-Year Exp.
Ann. Ret. (%)

IDEC Pharma. (IDPH) +Avg 49.00 34.05 18.88
First Data (FDC) -Avg 53.00 36.74 16.79
Alliance Capital (AC) Avg 42.00 31.75 15.84
Eaton Vance (EV) Avg 45.00 35.65 15.28
Data as of 11-07-03.

One final note: I want to thank Jerry Gruber, one of our most astute subscribers, for e-mailing me about this very issue last week as I was writing this column. Using  Premium Stock Screener, Mr. Gruber crunched his own set of numbers and came to roughly the same conclusion I did--quality stocks are about fairly valued, low-quality stocks are not. In his words: "It appears the 'lesser quality' companies are currently the most overvalued. ... I agree with a recent observation of yours that there are still pretty slim pickings when one factors in the requisite margin of safety."

I couldn't have said it better myself.

Mark Sellers does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.