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Apple, Inc. AAPL
Last Price 325.90 USD Fair Value 475.00 USD Consider Buy 332.50 USD

[Nasdaq]
Consider Sell 665.00 USD

|

QQQQQ
Uncertainty Medium Economic Moat Narrow
TM

Stewardship B

Morningstar Credit Rating Industry Computer Systems .

First Take on Apple’s 2Q--Blowout. Operating Income Up 98% off of 83% Revenue Growth.
by Joseph Beaulieu Senior Stock Analyst Analysts covering this company do not own its stock. Pricing data through June 10, 2011. Rating updated as of June 10, 2011. Currency amounts expressed with "$" are in U.S. dollars (USD) unless otherwise denoted.

together and operating margins rose to 31.9% from 29.5% in the year-ago quarter.

Analyst Note Apr. 20, 2011

Thesis Apr. 05, 2011

We are sticking with our $475 fair value estimate for Apple after reviewing the company’s second-quarter results. Revenue increased 83%, driven by 126% iPhone revenue growth, 32% Mac revenue growth, $2.8 billion of iPad sales (there isn’t a year-over-year growth figure because the iPad was released later in 2010), 23% in iTunes revenue, 17% growth in software sales, and 23% growth in revenue from peripherals. This growth was partially offset by a 14% decline in iPod revenue. Our investment thesis has been that the firm would see broad-based growth across its entire product portfolio (excepting the iPod, which is being cannibalized by the iPhone); based on second-quarter results we think our thesis remains intact. One area in which our thesis appeared at first to not quite hold up this quarter was on the gross margin line. Apple actually saw a small amount of gross margin contraction, to 41.4% from 41.7% in the year-ago quarter. However, it is important to note that although software and iTunes revenue grew an impressive 17% and 23%, respectively, this was much slower than the revenue growth of 93% for the the combination of iPod, iPad, iPhone, hardware peripherals, and Macs. Given that we think software and iTunes have significantly higher gross margins than hardware, our guess is that gross margins improved for most (if not all) categories, but the overall gross margin decline was from the mix shift. Apple also beat our expectations on operating expenses. We’ve been modeling long-term selling, general, and administrative expenses at about 8% of sales, and R&D at 3%-3.5% of sales. In the second quarter, those figures numbers were 7.1% and 2.4%, respectively. These represent a significant improvement over the prior year’s 9% and 3.2%. Put gross margins and operating expenses

Stock Price
281.0

193.0

In the past decade, Apple has transformed itself from a niche computer company into an integrated consumer electronics and media distribution powerhouse. It is now one of the most valuable companies in the world, achieving this position through a combination of product innovation, strategic foresight, and careful management of its brand image. We believe Apple has dug itself a narrow but widening economic moat that is based primarily on iOS, the operating system behind the iPhone and the iPad. While iOS is now the primary driver of Apple’s growth, we are excited to see that the firm is applying what it has learned from iOS to its OS X operating system for desktops and notebooks. In our view, the seeds of Apple’s success were sown in 2001 with the March release of OS X, the May launch of the first Apple retail store, and the October release of the first-generation iPod. The retail stores gave potential customers a place to gain hands-on experience with Apple’s products; the iPod gave the uninitiated a reason to go to the Apple store; and the launch of the robust, intuitive OS X helped Apple to gain market share in desktops and notebooks. From there, new products and services appeared to just fall into place--the iTunes Store for purchasing music; new iPod models for different purposes; video playback on the iPod combined with the distribution of video content on the iTunes Store; and finally, the iPhone, which leveraged Apple’s experience in developing handheld electronics, software design, and media distribution. We think the iPhone cemented Apple’s economic moat. The iPhone and now the iPad run on iOS, which we believe has the potential to hold nearly as strong a position in high-end portable computing devices as Windows has in the desktop market. (We use the modifiers "potential" and "nearly" here, as iOS has a much stronger competitor in Android than Windows ever had.) Already, iOS has a

104.0 84.0 07 08 09 10 11

which by some estimates accounts for more than 80% of the nascent tablet computing market.4 billion in 2006 to $17.90 USD Fair Value 475. product managers. Although Apple has an abundance of talented developers. We’ve also modeled more rapid market share gains in Apple’s legacy desktop and notebook computer businesses. which has enticed a massive number of developers to create applications for iOS. Microsoft Corporation Hewlett-Packard Company Dell. While we believe the network effects and modest switching costs are partially responsible for Apple’s continued revenue growth and expanding profitability. Additionally.S. and international launches of the iPad 2.451 68. is that the availability of third-party applications has been extremely limited compared with Windows. © 2011 Morningstar. Anything that tarnishes the brand could quickly undo what it took the past decade to achieve.941 61. call +1 312-696-6869.239 easy for consumers to install applications and to keep their applications library up to date with one click. Morningstar data as of June 10. and we think the launch of the Mac App Store could accelerate market share increases.980 4. This report is for information purposes only. To order reprints. it is important to recognize that revenue from those products has been steadily growing--from $7. you may use this report only in the country in which its original distributor is based. and iPad work in conjunction with Windows-based computers as well. Inc. which in turn increases the appeal of the iOS platform for consumers.5 billion in 2010--despite the fact that the iPod.552 21. Inc. Despite a full decade of continuous successes under its belt.794 9. The biggest legitimate knock against Apple’s PCs.899 73.50 USD [Nasdaq] Consider Sell 665. Moreover. Apple can now distribute third-party applications directly to consumers.637 Oper Income 25. Apple has steadily gained share in the notebook and desktop market throughout the past decade. Redistribution is prohibited without written permission. The information contained herein is not represented or warranted to be accurate. engineers. call +1 312-696-6100. This was exacerbated by the fact that third-party software produced for the Mac got extremely limited retail distribution. We therefore believe the Mac App Store has the potential to drive further market share gains. strong network effect.220 3. Apple is already leveraging the success of the iPhone with the launch of the iPad. complete. we think the intangibles associated with the Apple brand are just as important to the company’s ongoing success. Currency(Mil) USD USD USD USD Market Cap 301. Data as originally reported. 2011. ß ® . but we’ve also increased our expectation for PC sales. With the Mac App Store. in our view. correct.00 USD Consider Buy 332. Although Apple’s desktop and notebook revenue is now only two thirds the size of iPhone revenue. Unless otherwise provided in a separate agreement. there is still the potential for things to go wrong at Apple. as consumers invest more money in iOS applications and media from the iTunes Store. iPhone.615 127. This is why we think investors are right to be concerned about the potential for Steve Jobs’ permanent departure from Apple. switching costs will grow.185 TTM Sales 87.114 29. AAPL Last Price 325. Most of this increase is due to higher expectations for iPad sales after the strong U. and should not be considered a solicitation to buy or sell any security.126 Net Income 19. we think Jobs’ leadership has been instrumental to pull those people together and prevent any truly bad products from making it out the door. and marketers. To license the research. as the vast number of iPhones in customers’ hands has created a massive market for third-party applications.Apple. or timely. All Rights Reserved.378 199. Inc.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems . Close Competitors Apple. We still expect Apple’s share of the smartphone market to top out at around 15% by 2015.920 11. it makes it easy for consumers to review applications (thus making it less risky to try new applications) and makes it extremely Valuation.382 26. Growth and Profitability We are increasing our fair value estimate to $475 per share from $460. We now expect 2014 iPad sales to come to about 75 million units (up from our previous 40 million estimate) and think iPad sales will hit 80 million units (about $45 billion) in 2015.

This report is for information purposes only.50 USD [Nasdaq] Consider Sell 665. We think this image is deserved. since the firm has gone a full decade without a significant flop. To order reprints. but we’d worry about how long Apple’s winning streak could continue after that. Unless otherwise provided in a separate agreement.90 USD Fair Value 475. ß ® . exposing the firm to significant customer concentration risk in the event of a big economic downturn. We continue to be surprised at the number of first-time Mac customers the firm adds every year. But we also believe Jobs’ product. Redistribution is prohibited without written permission. It carries no debt. While we think Apple has an economic moat. We don’t expect a significant change in the firm’s cost structure. Although it has a significant international presence.5% from 40%. consumers and high-priced products. We believe the iPod business will contract at a 10% per year on volume. call +1 312-696-6100. and should not be considered a solicitation to buy or sell any security.and user-focused vision has been instrumental to Apple’s renaissance and has served investors incredibly well. A downturn in the U. holds another $25 billion in long-term investments. we’ve boosted our long-term gross margin target to 42.S. But if the brand becomes tarnished. you may use this report only in the country in which its original distributor is based. would probably weigh on sales growth. The other major risk for shareholders is the firm’s heavy dependence on U. Apple’s retail stores provide a platform for exposing new consumers to the breadth of the company’s expanding product line. or timely.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems .. software puts iOS at less risk than Android. With less than 5% share worldwide. which runs the risk of fragmentation. Bears Say Risk In our view. As we believe the iPad will remain very successful and will drive increased sales of high-margin applications and media. and our valuation assumes that the iPad becomes a significant growth driver.5 billion in free cash flows in fiscal 2010. all bets are off. complete. To license the research. or a worldwide economic downturn.S. © 2011 Morningstar. We think he deserves much of the credit for Apple’s tremendous success during the past decade. We think COO Tim Cook is an able manager and Apple has an extremely deep talent pool. Financial Overview Bulls Say The iOS mobile operating system is likely to be part of a duopoly with Google’s Android. Inc. we would expect a couple of years of smooth sailing. However. call +1 312-696-6869. If either the iPhone or iPad disappoints. but we think that Apple’s integrated control of both hardware and Financial Health: The company has $26 billion in cash and short-term investments. we still think iPods will have a place in the iOS ecosystem. The information contained herein is not represented or warranted to be accurate. Nearly 40% of Apple’s revenue comes from the iPhone line. Data as originally reported. correct.S. economy. Steve Jobs’ recurring health problems are a legitimate concern. our fair value estimate will fall.Apple. We think the Mac App Store will accelerate share gains. the high price points of its products could limit growth in emerging markets. the Mac computer can continue to increase its share as a capable Windows alternative. AAPL Last Price 325. and his long-term absence could deal a heavy blow to the company. as it did in fiscal 2009. Apple’s sales are concentrated in the U. If Jobs were to leave the firm on a permanent basis. and has generated $16. so we think operating margins will hit north of 30%. much of its ability to open customers’ wallets is based on its brand image. Apple’s success during the past decade is largely attributable to the leadership of Steve Jobs. but expect revenue to contract at about 18% per year as iPod average selling prices fall and more consumers replace their dedicated MP3 devices with converged devices such as the iPhone. All Rights Reserved.00 USD Consider Buy 332.

Apple. Management: Steve Jobs cofounded Apple in 1976 and rejoined the company as CEO in 1997. call +1 312-696-6869. Inc. Though the stock-option backdating scandal raises our stewardship concerns. an online store that sells first. This report is for information purposes only. Jobs’ health is a significant concern. and the iPod.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems . Data as originally reported. Apple launched the Mac App Store. the iPhone. the iPad. As such. and should not be considered a solicitation to buy or sell any security. Unless otherwise provided in a separate agreement. Its iTunes online store is the largest music distributor in the world. Company Overview Profile: Apple designs consumer electronic devices. To order reprints.90 USD Fair Value 475. including PCs. call +1 312-696-6100. Apple’s products are distributed online as well as through company-owned stores and third-party retailers. Redistribution is prohibited without written permission. The majority of executive compensation is aligned with shareholder interests in the form of restricted stock units tied to long-term company performance. Apple has taken other steps in the right direction. ß ® . you may use this report only in the country in which its original distributor is based. AAPL Last Price 325. it sells and rents TV shows and movies and sells applications for the iPhone and iPad. He has personally recruited much of the current management team. Apple’s executives have been richly rewarded as a result of the company’s tremendous performance. or timely. and most have worked with him for a long time. but the vast majority of compensation comes from equity as opposed to cash. CFO Peter Oppenheimer has been with the company since 1996. All Rights Reserved.50 USD [Nasdaq] Consider Sell 665. The information contained herein is not represented or warranted to be accurate. including the appointment of lead codirectors in 2006. correct. but is somewhat alleviated by the fact that the company maintains a talented management bench and culture of innovation that will sustain it in the near term. complete.and third-party applications for the Mac line of desktop and notebook computers. COO Tim Cook came to Apple from Compaq in 1998.00 USD Consider Buy 332. In early 2011. To license the research. we believe aggressive moves by the board have enabled the company to turn the page. © 2011 Morningstar.

All Rights Reserved.2%. Revenue increased 83%. One area in which our thesis appeared at first to not quite hold up this quarter was on the gross margin line. Apple also beat our expectations on operating expenses. iPad. 20. Disclaimers & Disclosures No Morningstar employees are officers or directors of this company. 2011 First Take on Apple’s 2Q--Blowout.7% in the year-ago quarter. 23% in iTunes revenue. respectively. and should not be considered a solicitation to buy or sell any security. it is important to note that although software and iTunes Jan. those figures numbers were 7. This report is for information purposes only.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems . and Macs. However. To license the research. Our investment thesis has been that the firm would see broad-based growth across its entire product portfolio (excepting the iPod. you may use this report only in the country in which its original distributor is based. We are sticking with our $475 fair value estimate for Apple after reviewing the company’s second-quarter results. general. 32% Mac revenue growth. This growth was partially offset by a 14% decline in iPod revenue. ß ® . The information contained herein is not represented or warranted to be accurate. Morningstar Inc. but the overall gross margin decline was from the mix shift. driven by 126% iPhone revenue growth. This report is for information purposes only. but if he were to hand over leadership on a permanent basis. 18. 17% growth in software sales. which is being cannibalized by the iPhone).5% in the year-ago quarter. as we view his leadership as an important factor in the firm’s success over the past decade. We are putting our fair value estimate for Apple under review while we transition coverage of the company to a different analyst. to 41. Analysts covering this company do not own its stock. To order reprints. and should not be considered a solicitation to buy or sell any security. Apple actually saw a small amount of gross margin contraction. complete. and 23% growth in revenue from peripherals. call +1 312-696-6100. our guess is that gross margins improved for most (if not all) categories.90 USD Fair Value 475.1% and 2. hardware peripherals. Steve Jobs’ second leave of absence is certainly a matter of concern. and administrative expenses at about 8% of sales. complete. iPhone. $2. Given that we think software and iTunes have significantly higher gross margins than hardware. or timely. Put gross margins and operating expenses together and operating margins rose to 31. © 2011 Morningstar.50 USD [Nasdaq] Consider Sell 665. AAPL Last Price 325. Inc. We think Apple can function perfectly well in the near to intermediate term in his absence. 2011 Apple Under Review revenue grew an impressive 17% and 23%. These represent a significant improvement over the prior year’s 9% and 3.Apple. based on second-quarter results we think our thesis remains intact. Data as originally reported. correct. Analyst Notes Apr. this was much slower than the revenue growth of 93% for the the combination of iPod.5% of sales. respectively.8 billion of iPad sales (there isn’t a year-over-year growth figure because the iPad was released later in 2010).9% from 29. We’ve been modeling long-term selling. does not own more than 1% of the shares of this company. and R&D at 3%-3. or timely. The information contained herein is not represented or warranted to be accurate. correct.00 USD Consider Buy 332. Redistribution is prohibited without written permission.4% from 41. we’d have to reassess our long-term view. Unless otherwise provided in a separate agreement. call +1 312-696-6869.4%. In the second quarter. Operating Income Up 98% off of 83% Revenue Growth.

7 25.1 22.5 1.08 0.0 57.8 19.9 . 16.9 13.9 146.0 56.00 878 13.90 79.93 0. 72901 173427 2006 2007 -56.00 775 7.1 .6 12.5 14. 46.7 65.00 724 5.8 .5 1.3 -1.7 Jun 10 25.3 Dec 10 82.7 . 23.5 15. 33427 61477 Mkt -0.9 276 0.2 20.4 -25 -0.13 1.1 1.4 18385 28.8 .1 25382 29.00 925 52.7 17.36 0.0 8337.68 12.19 5470 -986 4484 2007 32479 34.59 93.7 5. 0.90 .0 133.3 105. Redistribution is prohibited without written permission.0 19552 20.2 38.6 2010 25.10 0.5 19.9 1. . 2004 6816 . Its iTunes online store is the largest music distributor in the world. All Rights Reserved.and third-party applications for the Mac line of desktop and notebook computers.3 19.00 727 5.4 10. and should not be considered a solicitation to buy or sell any security. To license the research.5 13.6 12.0 18. 6. 2009 20956 .66 364.16 Price Volatility 199.0 Jun 10 Sep 10 Dec 10 Mar 11 Apple.5 0.3 15.10 18595 -2005 16590 2010 87451 39.7 2007 14. 47791 .8 .8 22.0 Revenue/Employee USD K1770. 1.1 30.6 66.5 12.3 11. 10.9 11.3 9.64 185 -232 -47 2001 5742 27.61 6.1 22.apple.1 11740 27.9 . 14. The information contained herein is not represented or warranted to be accurate.9 3. .9 Mkt 47. Apple’s products are distributed online as well as through company-owned stores and third-party retailers. call +1 312-696-6869. ß ® .4 26. 21030 . 2007 20598 .0 2453 12.6 4.00 857 9. 4. 5146 2002 49.09 0.3 1.6 2005 13.2 30. 2.0 Growth Rates Compound Annual Grade: A 1 Yr 3 Yr 5 Yr 10 Yr 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 YTD Stock Performance Total Return % +/. otherwise most recent annual data shown.11 1.00 907 39.00 691 5.26 213. 10.3 1.4 30.4 0.3 1137. 24327 .9 2.0 4409 18.4 Fixed Asset Turns 17.8 0.5 1.48 26476 -3193 23283 TTM Revenue USD Mil Gross Margin % Oper Income USD Mil Operating Margin % Net Income USD Mil Earnings Per Share USD Dividends USD Shares Mil Book Value Per Share USD Oper Cash Flow USD Mil Cap Spending USD Mil Free Cash Flow USD Mil Profitability Return on Equity % 38. and the iPod.40 3. 6. TTM data based on rolling quarterly data if available.5 .1 0.9 53.Morningstar ® Stock Data Sheet Pricing data thru Jun.com 6.3 1. 5076 .4 8235 9. To order reprints.00 75.5 2002 1.95 326.5 -1 0 69 0.9 5.3 16.0 19.4 52. 9. 23.3 1.Market +/. *3Yr Avg data is displayed in place of 5Yr Avg © 2011 Morningstar.5 68615 9.1 1. 48. In early 2011.2 1.6 2004 13.7 10.9 31.8 22.6 .2 14013 15.3 . 25893 2004 123.3 326 3. Morningstar Rating Sales USD Mil Mkt Cap USD Mil Industry Sector 87.5 17.9 0.0 3.51 1.04 0.4 192.90 475.78 10.7 11.5 4.2 -34.67 6.8 30.3 27.4 39. .8 35.4 1.8 10.5 17.6 -11.6 29. 9984 . the iPhone. 13. AAPL Apple designs consumer electronic devices.0 .3 11.3 120.00 1.4 123. CA 95014 Phone: 1 408 996-1010Website: http://www. Microsoft Corporatio Hewlett-Packard Comp Major Fund Holders 301378 199899 73114 87451 15. 60587 2005 18. .27 0. correct.1 1.25 81.9 32.33 .89 289 -164 125 2003 8279 27.1 Ind 23.00 931 66.1 .5 12.0 24667.0 -18. an online store that sells first. 1.46 31.73 89 -174 -85 2002 6207 27. 7859 2003 201.0 -344 -6.5 40.0 17. Data as originally reported. .5 12. complete.1 -84.4 42.2 4.378 Uncertainty Computer Systems Economic Moat TM Technology Stewardship Grade QQQQQ 13.07 2220 -657 1563 2006 24006 34.3 .1 29. call +1 312-696-6100. 2006 12657 .8 .9 .6 2003 3.6 1.2 * Gross Margin % Operating Margin % Net Margin % Free Cash Flow/Rev % R&D/Rev % Financial Position Grade: A 09-10 USD Mil 35. 4.4 Mar 11 % of shares Most Recent Period Prior Year Period 3.09 6.6 .0 21.0 03-11 USD Mil Cash Inventories Receivables Current Assets Fixed Assets Intangibles Total Assets Payables Short-Term Debt Current Liabilities Long-Term Debt Total Liabilities Total Equity Valuation Analysis Current 11261 1051 9924 41678 4768 1083 75183 12225 .08 2001 3730 316 4095 0.15 0.2 8.5 Most Recent Period Prior Year Period Rev Growth % 15700.0 Return on Assets % 25.25 320. 61477 .5 .5 11.9 3. 20722 .6 4. 4223 .6 .5 0.9 1.0 13499.2 16.2 20.6 36. you may use this report only in the country in which its original distributor is based.0 .0 8.4 28.99 1.1 19.5 Price/Earnings P/E vs.4 130.0 1.5 61.3 21.3 7.20 190.1 40.8 1335 1.3 14.Industry Dividend Yield % Market Cap USD Mil Financials Revenue % Operating Income % Earnings/Share % Dividends % Book Value/Share % Stock Total Return % +/. Unless otherwise provided in a separate agreement.35 4.2 46.6 21. 32.5 2009 22.56 0.9 41.22 325.36 Bear-Market Rank 6 (10=worst) Trading Volume Million 1 Infinite Loop Cupertino.7 38.7 .0 Monthly High/Low Rel Strength to S&P 500 52 week High/Low 364.1 11.7 1989 2.6 6. including PCs.8 44.5 54.73 9596 -1199 8397 2008 42905 40.9 16.30 2:1 Medium Narrow B per share prices in USD Annual Price High Low Recent Splits 13.56 7.1 146. 27392 47791 5 Yr Avg Ind 15978 930 11095 46997 6241 1248 94904 14645 .4 13.5 03-11 Return on Assets % Return on Equity % Net Margin % Asset Turnover Financial Leverage Financial Health 3625 317 3920 0. 7466 .1 29.99 0.7 42. 42.0 56.9 39.4 101.9 2008 18.235.3 3.43 3.0 59.6 -0.90 . 3. the iPad. 14532 .0 1. it sells and rents TV shows and movies and sells applications for the iPhone and iPad.4 Inventory Turns 68.16 202.0 20343. 31640 . Market Price/Sales Price/Book Price/Cash Flow Quarterly Results Revenue USD Mil Jun 10 Sep 10 Dec 10 Mar 11 Industry Peers by Market Cap Mkt Cap USD Mil Rev USD Mil P/E ROE% Price/Earnings Forward P/E Price/Cash Flow Price/Free Cash Flow Dividend Yield % Price/Book Price/Sales PEG Ratio 15.95 1.7 50.7 2006 16. 2011 Fiscal year-end: September Apple.8 29. 2. Apple launched the Mac App Store.6 1.7 38.0 3.7 1.0 16238.3 122.8 19.0 26741.0 54. 2008 20049 .8 .0 1.84 1.51 6.7 956.5 0.2 60.6.96 200.9 27.451 Last Price Fair Value 301.8 7.08 2002 3530 .8 .2 0.1 5. 2010 22670 .8 .56 10 Year High/Low 364.4 -0.Industry +/.34 1. This report is for information purposes only.06 1. . or timely.0 39.36 0. 2003 4375 .1 .8 43.5 .7 48.8 11.2 40.1 0.00 889 19.15 1.42 1.0 . 75997 190983 297089 301378 2008 2009 2010 TTM 5363 23.93 1.4 200.0 57.2 14. 2011 Rating updated as of Jun.94 2535 -260 2275 2005 19315 29.90 50. 3.3 15. TTM Working Capital USD Mil Long-Term Debt USD Mil Total Equity USD Mil Debt/Equity Valuation 36.8 .1 9.14 78.0 15683.7 0.7 Sep 10 70.3 1.3 65 0. 2005 8038 .0 Current 39.9 17 0.5 5 Yr Avg 36.3 4834 5.36 34.4 .3 33. Inc. 7703 2001 -34.7 Most Recent Period Prior Year Period Earnings Per Share USD 88.2 62.4 21.4 3496 3.Market Profitability Analysis Grade: A 52. Inc.64 4.3 20.8 7.47 10159 -1144 9015 2009 65225 39.5 2001 1.4 35.6 1.6 2.0 19.20 934 -176 758 2004 13931 29.0 1650 11.5 4.4 127941 8.0 22.3 6275 19.00 902 25.

so our ratings always reflect our analyst’s current opinion. and thus in our value estimates. but market prices do. Our fair value estimates don’t change very often. Analyst conducts company and industry research: Management interviews Conference calls Trade-show visits Competitor. and then adjusting the total for timing and risk. usually by virtue of some competitive advantage. All Rights Reserved. for a simple reason: We have more confidence in our cash-flow forecasts for strong companies. An uncertainty assessment establishes the margin of safety required for the stock rating. we monitor market events and all of our stocks every business day. rather than short-term movements in stock prices. To license the research. We calculate our star ratings nightly after the markets close. distributor. Because we focus on the long-term value of businesses. which is why the rating date on our reports will always be the previous business day. relatively few will receive our highest rating of 5 stars. a stock may gain or lose stars based just on movement in the share price. © 2011 Morningstar. Economic Moat Rating TM The Economic Moat Rating is our assessment of a firm’s ability to earn returns consistently above its cost of capital in the future. Unless otherwise provided in a separate agreement. and the shares decline to $40 without much change in the value of the business. complete. DCF model leads to the firm’s Fair Value Estimate. Redistribution is prohibited without written permission. Even the best company is a bad deal if an investor overpays for its shares. When stocks are high. we evaluate stocks as pieces of a business. call +1 312-696-6100. Cash generated next year is worth more than cash generated several years down the road. Our estimate of what the business is worth hasn’t changed. To order reprints. Assumptions are input into a discounted cash-flow model. This report is for information purposes only. and customer interviews The depth of the firm’s competitive advantage is rated: None Narrow Wide Analyst considers company financial statements and competitive position to forecast future cash flows. and issue them the following business day. If a stock’s market price is significantly above our fair value estimate. usually about once or twice per quarter. That is why you’ll see two dates on every Morningstar stock report. we require a smaller discount than for mediocre ones. which anchors the rating framework. For high-quality businesses. the star rating will go up. call +1 312-696-6869. not as pieces of paper. many more will likely garner 5 stars. Competition tends to drive down such TM Morningstar Research Methodology for Valuing Companies Competitive Analysis Economic TM Moat Rating Company Valuation Fair Value Estimate Uncertainty Assessment QQQQQ Q QQ QQQ QQQQ QQQQQ The current stock price relative to fair value. Although you might expect to see more 5-star stocks as the market rises. or timely. we find assets more attractive when they’re cheap. adjusted for uncertainty. supplier. So. you may use this report only in the country in which its original distributor is based. with 5 the best and 1 the worst. determines the rating. at times we may appear out of step with the overall stock market. Stocks trading at meaningful discounts to our fair value estimates will receive high star ratings. and should not be considered a solicitation to buy or sell any security. and cash from a stable and consistently profitable business is worth more than cash from a cyclical or unsteady business. but the shares are more attractive as an investment at $40 than they were at $50. The information contained herein is not represented or warranted to be accurate. If we think a stock’s fair value is $50. But when the market tumbles. it will receive a low star rating. Our analysts arrive at this "fair value estimate" by forecasting how much excess cash--or "free cash flow"--the firm will generate in the future. Our star rating is based on our analyst’s estimate of how much a company’s business is worth per share. ß ® .Morningstar’s Approach to Rating Stocks Our Key Investing Concepts Economic Moat Rating Discounted Cash Flow Discount Rate Fair Value Uncertainty Margin of Safety Consider Buying/Consider Selling Stewardship Grades TM At Morningstar. correct. We update the text of our reports as new information becomes available. Of course. We think that purchasing shares of superior businesses at discounts to their intrinsic value and allowing them to compound their value over long periods of time is the surest way to create wealth in the stock market. Data as originally reported. no matter how wonderful we think the business is. We rate stocks 1 through 5 stars.

We require larger margins of safety for less predictable stocks. Data as originally reported. analysts consider factors such as sales predictability. it’s a long-term estimate. This report is for information purposes only." than for a firm in a cyclical business with fierce competition. whereas price targets generally focus on the next two to 12 months. We aim to identify firms that provide investors with insufficient or potentially misleading financial information. we deduct from a company’s fair value if it has issued a lot of stock options or has an under-funded pension plan. Redistribution is prohibited without written permission. Discount Rate We use this number to adjust the value of our forecasted cash flows for the risk that they may not materialize. seek to limit the power of minority shareholders. ß ® . First. complete. The information contained herein is not represented or warranted to be accurate. Discounted Cash Flow Margin of Safety This is a method for valuing companies that involves projecting the amount of cash a business will generate in the future." and F means "Very Poor. call +1 312-696-6869. subtracting the amount of cash that the company will need to reinvest in its business. Our fair value estimate differs from a "target price" in two ways. and thus the point at which we would consider the stock an extremely attractive purchase. and ownership. also known as "cost of capital. Consider Buying/Consider Selling The consider buying price is the price at which a stock would be rated 5 stars. operating leverage. correct. Analysts then classify their ability to bound the fair value estimate for the stock into one of several uncertainty levels: Low. We adjust our fair values for off-balance sheet liabilities or assets that a firm might have--for example. and is our per-share estimate of a company’s intrinsic worth. and the greater the premium to fair value before a stock earns a 1-star rating." B means "Good. it’s an estimate of what the business is worth. allow management to abuse its position. Unless otherwise provided in a separate agreement. the greater the discount to fair value required before a stock can earn 5 stars." Uncertainty To generate the Morningstar Uncertainty Rating. with low expected returns relative to its risk. This is the discount to fair value we would require before recommending a stock. incentives. and smaller margins of safety for more predictable stocks. call +1 312-696-6100. Fair Value This is the output of our discounted cash-flow valuation models. and should not be considered a solicitation to buy or sell any security. since there’s less risk clouding the firm’s future. at which point we’d consider the stock overvalued. To order reprints. For a profitable company in a steady line of business. High. To license the research. The grades are assigned on an absolute scale--not relative to peers--and can be interpreted as follows: A means "Excellent.The margin of safety is like an insurance policy that protects investors from bad news or overly optimistic fair value estimates.Morningstar’s Approach to Rating Stocks (continued) economic profits. and using the result to calculate the worth of the firm. Second. whereas a price target typically reflects what other investors may pay for the stock. Very High. shareholder friendliness. or Extreme. Medium. We think it’s always prudent to buy stocks for less than they’re worth. All Rights Reserved. We use this technique to value nearly all of the companies we cover. consider selling is the price at which a stock would have a 1 star rating. The greater the level of uncertainty. or timely. © 2011 Morningstar." C means "Fair. Conversely. but companies that can earn them for an extended time by creating a competitive advantage possess an Economic Moat. you may use this report only in the country in which its original distributor is based. and financial leverage." D means "Poor. we’ll use a lower discount rate. Stewardship Grades We evaluate the commitment to shareholders demonstrated by each firm’s board and management team by assessing transparency. or which have management incentives that are not aligned with the interests of long-term shareholders. We see these companies as superior investments.