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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

Currency(Mil) USD USD USD USD Market Cap 301. Apple can now distribute third-party applications directly to consumers.382 26. and marketers. This is why we think investors are right to be concerned about the potential for Steve Jobs’ permanent departure from Apple. Inc. Apple is already leveraging the success of the iPhone with the launch of the iPad. 2011. 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. is that the availability of third-party applications has been extremely limited compared with Windows.451 68. To license the research. as the vast number of iPhones in customers’ hands has created a massive market for third-party applications. or timely. we think the intangibles associated with the Apple brand are just as important to the company’s ongoing success. All Rights Reserved.378 199.920 11.899 73. Anything that tarnishes the brand could quickly undo what it took the past decade to achieve.615 127. Despite a full decade of continuous successes under its belt.126 Net Income 19. and should not be considered a solicitation to buy or sell any security. Inc. but we’ve also increased our expectation for PC sales.114 29. we think Jobs’ leadership has been instrumental to pull those people together and prevent any truly bad products from making it out the door. Microsoft Corporation Hewlett-Packard Company Dell.5 billion in 2010--despite the fact that the iPod. Close Competitors Apple. Inc. Redistribution is prohibited without written permission. and iPad work in conjunction with Windows-based computers as well. To order reprints. Additionally.50 USD [Nasdaq] Consider Sell 665.185 TTM Sales 87. We still expect Apple’s share of the smartphone market to top out at around 15% by 2015. Morningstar data as of June 10. which by some estimates accounts for more than 80% of the nascent tablet computing market.Apple.4 billion in 2006 to $17. iPhone. The information contained herein is not represented or warranted to be accurate. ß ® .552 21.794 9.220 3. With the Mac App Store. While we believe the network effects and modest switching costs are partially responsible for Apple’s continued revenue growth and expanding profitability. which has enticed a massive number of developers to create applications for iOS.90 USD Fair Value 475. complete. Moreover. you may use this report only in the country in which its original distributor is based. Although Apple’s desktop and notebook revenue is now only two thirds the size of iPhone revenue. and we think the launch of the Mac App Store could accelerate market share increases.941 61. call +1 312-696-6869. Most of this increase is due to higher expectations for iPad sales after the strong U. We therefore believe the Mac App Store has the potential to drive further market share gains.637 Oper Income 25. as consumers invest more money in iOS applications and media from the iTunes Store. engineers. Unless otherwise provided in a separate agreement. Growth and Profitability We are increasing our fair value estimate to $475 per share from $460.239 easy for consumers to install applications and to keep their applications library up to date with one click.980 4. there is still the potential for things to go wrong at Apple.00 USD Consider Buy 332. © 2011 Morningstar. it makes it easy for consumers to review applications (thus making it less risky to try new applications) and makes it extremely Valuation. it is important to recognize that revenue from those products has been steadily growing--from $7.S. Although Apple has an abundance of talented developers. This report is for information purposes only. and international launches of the iPad 2. call +1 312-696-6100. AAPL Last Price 325. switching costs will grow. This was exacerbated by the fact that third-party software produced for the Mac got extremely limited retail distribution. We’ve also modeled more rapid market share gains in Apple’s legacy desktop and notebook computer businesses. product managers. which in turn increases the appeal of the iOS platform for consumers.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems . Apple has steadily gained share in the notebook and desktop market throughout the past decade. The biggest legitimate knock against Apple’s PCs. strong network effect. in our view. correct. Data as originally reported.

or timely.. Redistribution is prohibited without written permission. AAPL Last Price 325. much of its ability to open customers’ wallets is based on its brand image. We think COO Tim Cook is an able manager and Apple has an extremely deep talent pool. Although it has a significant international presence. To order reprints. and his long-term absence could deal a heavy blow to the company. and should not be considered a solicitation to buy or sell any security. we still think iPods will have a place in the iOS ecosystem. exposing the firm to significant customer concentration risk in the event of a big economic downturn. However.S. Bears Say Risk In our view. If either the iPhone or iPad disappoints. the high price points of its products could limit growth in emerging markets. We think he deserves much of the credit for Apple’s tremendous success during the past decade. the Mac computer can continue to increase its share as a capable Windows alternative.Apple. All Rights Reserved. Unless otherwise provided in a separate agreement. 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. The information contained herein is not represented or warranted to be accurate. or a worldwide economic downturn. call +1 312-696-6869. would probably weigh on sales growth. To license the research. Data as originally reported. Apple’s retail stores provide a platform for exposing new consumers to the breadth of the company’s expanding product line. We believe the iPod business will contract at a 10% per year on volume.and user-focused vision has been instrumental to Apple’s renaissance and has served investors incredibly well. Financial Overview Bulls Say The iOS mobile operating system is likely to be part of a duopoly with Google’s Android. With less than 5% share worldwide. software puts iOS at less risk than Android. We think this image is deserved.90 USD Fair Value 475. But if the brand becomes tarnished. economy. consumers and high-priced products. A downturn in the U. This report is for information purposes only. holds another $25 billion in long-term investments. 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. complete. Apple’s sales are concentrated in the U. so we think operating margins will hit north of 30%. and our valuation assumes that the iPad becomes a significant growth driver. We don’t expect a significant change in the firm’s cost structure. ß ® .00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems . Steve Jobs’ recurring health problems are a legitimate concern.5 billion in free cash flows in fiscal 2010.00 USD Consider Buy 332. While we think Apple has an economic moat. © 2011 Morningstar. correct. call +1 312-696-6100. The other major risk for shareholders is the firm’s heavy dependence on U. we would expect a couple of years of smooth sailing. If Jobs were to leave the firm on a permanent basis.50 USD [Nasdaq] Consider Sell 665. we’ve boosted our long-term gross margin target to 42. and has generated $16. our fair value estimate will fall. Nearly 40% of Apple’s revenue comes from the iPhone line. As we believe the iPad will remain very successful and will drive increased sales of high-margin applications and media. since the firm has gone a full decade without a significant flop. We think the Mac App Store will accelerate share gains.S. It carries no debt. We continue to be surprised at the number of first-time Mac customers the firm adds every year. as it did in fiscal 2009. Inc. Apple’s success during the past decade is largely attributable to the leadership of Steve Jobs. all bets are off.S. But we also believe Jobs’ product. but we’d worry about how long Apple’s winning streak could continue after that.5% from 40%. you may use this report only in the country in which its original distributor is based. which runs the risk of fragmentation.

The majority of executive compensation is aligned with shareholder interests in the form of restricted stock units tied to long-term company performance. 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. an online store that sells first. Apple’s executives have been richly rewarded as a result of the company’s tremendous performance. Company Overview Profile: Apple designs consumer electronic devices. complete. COO Tim Cook came to Apple from Compaq in 1998. call +1 312-696-6100. He has personally recruited much of the current management team. To license the research. Apple launched the Mac App Store. This report is for information purposes only. and should not be considered a solicitation to buy or sell any security. call +1 312-696-6869.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems . ß ® .50 USD [Nasdaq] Consider Sell 665. CFO Peter Oppenheimer has been with the company since 1996. Apple has taken other steps in the right direction.Apple. AAPL Last Price 325. correct. Management: Steve Jobs cofounded Apple in 1976 and rejoined the company as CEO in 1997. it sells and rents TV shows and movies and sells applications for the iPhone and iPad. As such. or timely. you may use this report only in the country in which its original distributor is based. we believe aggressive moves by the board have enabled the company to turn the page. To order reprints. Unless otherwise provided in a separate agreement. including the appointment of lead codirectors in 2006. and the iPod. All Rights Reserved. Though the stock-option backdating scandal raises our stewardship concerns. Redistribution is prohibited without written permission. including PCs. Apple’s products are distributed online as well as through company-owned stores and third-party retailers. but the vast majority of compensation comes from equity as opposed to cash. the iPad.and third-party applications for the Mac line of desktop and notebook computers. Data as originally reported. The information contained herein is not represented or warranted to be accurate. and most have worked with him for a long time. Inc. In early 2011. Its iTunes online store is the largest music distributor in the world.90 USD Fair Value 475. Jobs’ health is a significant concern. © 2011 Morningstar.00 USD Consider Buy 332. the iPhone.

In the second quarter. and 23% growth in revenue from peripherals. These represent a significant improvement over the prior year’s 9% and 3. Operating Income Up 98% off of 83% Revenue Growth. we’d have to reassess our long-term view. We are putting our fair value estimate for Apple under review while we transition coverage of the company to a different analyst.4%. complete. or timely. Inc. To license the research. This report is for information purposes only. This report is for information purposes only.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems . $2. ß ® . correct. to 41. call +1 312-696-6100. All Rights Reserved. 32% Mac revenue growth. The information contained herein is not represented or warranted to be accurate. or timely. and Macs. this was much slower than the revenue growth of 93% for the the combination of iPod.7% in the year-ago quarter. iPad. and should not be considered a solicitation to buy or sell any security. However. correct. hardware peripherals. 17% growth in software sales. Analysts covering this company do not own its stock. it is important to note that although software and iTunes Jan. Revenue increased 83%. respectively. and R&D at 3%-3. as we view his leadership as an important factor in the firm’s success over the past decade. Steve Jobs’ second leave of absence is certainly a matter of concern.50 USD [Nasdaq] Consider Sell 665.1% and 2. We’ve been modeling long-term selling.2%. but the overall gross margin decline was from the mix shift.5% of sales. driven by 126% iPhone revenue growth. Morningstar Inc. Our investment thesis has been that the firm would see broad-based growth across its entire product portfolio (excepting the iPod. based on second-quarter results we think our thesis remains intact. call +1 312-696-6869. does not own more than 1% of the shares of this company. We think Apple can function perfectly well in the near to intermediate term in his absence. 20.Apple. One area in which our thesis appeared at first to not quite hold up this quarter was on the gross margin line. general. but if he were to hand over leadership on a permanent basis. Apple also beat our expectations on operating expenses. 23% in iTunes revenue. respectively.4% from 41. Redistribution is prohibited without written permission.5% in the year-ago quarter. complete.8 billion of iPad sales (there isn’t a year-over-year growth figure because the iPad was released later in 2010). © 2011 Morningstar. you may use this report only in the country in which its original distributor is based. which is being cannibalized by the iPhone). Analyst Notes Apr. iPhone.9% from 29. 18. and administrative expenses at about 8% of sales. This growth was partially offset by a 14% decline in iPod revenue. The information contained herein is not represented or warranted to be accurate. Unless otherwise provided in a separate agreement. Disclaimers & Disclosures No Morningstar employees are officers or directors of this company. Apple actually saw a small amount of gross margin contraction.90 USD Fair Value 475. AAPL Last Price 325. 2011 Apple Under Review revenue grew an impressive 17% and 23%. Put gross margins and operating expenses together and operating margins rose to 31. those figures numbers were 7.00 USD Consider Buy 332. our guess is that gross margins improved for most (if not all) categories. Given that we think software and iTunes have significantly higher gross margins than hardware. To order reprints. Data as originally reported. and should not be considered a solicitation to buy or sell any security. 2011 First Take on Apple’s 2Q--Blowout. We are sticking with our $475 fair value estimate for Apple after reviewing the company’s second-quarter results.

1 1.8 10. the iPad. 10.1 Ind 23.1 11740 27.5 4.3 1. 2003 4375 .33 .73 9596 -1199 8397 2008 42905 40.0 15683.0 133.2 14013 15.73 89 -174 -85 2002 6207 27.20 934 -176 758 2004 13931 29.56 0.0 16238.5 03-11 Return on Assets % Return on Equity % Net Margin % Asset Turnover Financial Leverage Financial Health 3625 317 3920 0.6 21. To license the research.00 925 52. 48. This report is for information purposes only. To order reprints. call +1 312-696-6100.9 31.8 19.51 1. 2007 20598 .6 1. 32.95 326.1 0. 61477 .2 16.4 123. 27392 47791 5 Yr Avg Ind 15978 930 11095 46997 6241 1248 94904 14645 .9 2.0 1.3 Dec 10 82.7 2007 14.3 4834 5. CA 95014 Phone: 1 408 996-1010Website: http://www.00 75.3 33.9 . 2008 20049 .3 27.7 Most Recent Period Prior Year Period Earnings Per Share USD 88.9 3.00 857 9.93 1.9 13.4 192. *3Yr Avg data is displayed in place of 5Yr Avg © 2011 Morningstar.7 956.3 1. 4.07 2220 -657 1563 2006 24006 34. it sells and rents TV shows and movies and sells applications for the iPhone and iPad. Its iTunes online store is the largest music distributor in the world.4 35.8 .5 2009 22.34 1.5 -1 0 69 0.0 59.5 0.4 3496 3.3 65 0.9 Mkt 47.9 0.4 -0.00 931 66.4 30.3 19.7 1989 2.8 22.0 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 .84 1.95 1.and third-party applications for the Mac line of desktop and notebook computers.0 .1 40.5 13.11 1. 2.7 Jun 10 25.8 29. Morningstar Rating Sales USD Mil Mkt Cap USD Mil Industry Sector 87.5 12.3 122.9 41.0 Revenue/Employee USD K1770. 14532 .4 130.7 0.1 .6 4.90 .08 2002 3530 .6 1.6 2.5 .8 1335 1. 21030 .0 26741. .0 Current 39.Industry Dividend Yield % Market Cap USD Mil Financials Revenue % Operating Income % Earnings/Share % Dividends % Book Value/Share % Stock Total Return % +/.20 190. 7703 2001 -34.2 * Gross Margin % Operating Margin % Net Margin % Free Cash Flow/Rev % R&D/Rev % Financial Position Grade: A 09-10 USD Mil 35.93 0.2 46.6 12.4 200.Market +/.04 0.64 4. 1. 5146 2002 49.8 .4 52.4 101.0 19.1 30.42 1.4 39.00 775 7.5 5 Yr Avg 36.00 907 39.00 724 5.2 20.0 56. In early 2011.7 1.4 28.6 12.0 .9 17 0.1 0.6 . Apple launched the Mac App Store.3 3.3 1137.3 20.3 1.3 326 3. .3 15.4 .6 2003 3.9 1.0 8. 75997 190983 297089 301378 2008 2009 2010 TTM 5363 23.2 1.9 5.9 146.5 68615 9.0 1.8 7.5 2001 1.5 4.16 202.8 7.26 213.8 43.4 18385 28.2 20.0 Monthly High/Low Rel Strength to S&P 500 52 week High/Low 364. 20722 .0 2453 12.2 38.61 6.9 16.10 18595 -2005 16590 2010 87451 39. ß ® .08 2001 3730 316 4095 0. correct.5 1.apple. 23.1 146.5 11.10 0.com 6. 2006 12657 .4 26.0 17.8 44.0 1.5 54.36 Bear-Market Rank 6 (10=worst) Trading Volume Million 1 Infinite Loop Cupertino.4 Fixed Asset Turns 17.3 .3 .7 5.4 127941 8.7 38. 2011 Rating updated as of Jun.5 0.66 364.25 81.00 902 25.5 Most Recent Period Prior Year Period Rev Growth % 15700.3 105.378 Uncertainty Computer Systems Economic Moat TM Technology Stewardship Grade QQQQQ 13.64 185 -232 -47 2001 5742 27.0 13499.Industry +/. or timely.22 325.90 50.9 1.9 . 47791 .6 1. 10.8 11. 46.8 . .0 19552 20.43 3. Inc.0 54.7 17.1 1. 5076 .6 . 14.36 0.0 57.6 2010 25.8 . 33427 61477 Mkt -0.59 93. 23.Morningstar ® Stock Data Sheet Pricing data thru Jun.30 2:1 Medium Narrow B per share prices in USD Annual Price High Low Recent Splits 13.0 1650 11.67 6. an online store that sells first.78 10. 2004 6816 .0 8337.46 31.1 19. 1.96 200.1 -84.0 -18.6.25 320.5 15. 42.1 1.15 0.36 0.2 -34.56 10 Year High/Low 364.7 50.90 79.8 .94 2535 -260 2275 2005 19315 29. 9.00 1. 2010 22670 . 60587 2005 18.5 61.6 -0.0 20343.3 6275 19. 7859 2003 201.7 48.0 39.4 42.7 42.90 .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 % 38.08 0. AAPL Apple designs consumer electronic devices.7 . Apple’s products are distributed online as well as through company-owned stores and third-party retailers. Microsoft Corporatio Hewlett-Packard Comp Major Fund Holders 301378 199899 73114 87451 15.3 14.00 691 5. 3.5 17.40 3.5 .2 14. All Rights Reserved.8 .1 5. 9984 .8 30.00 727 5.9 3.47 10159 -1144 9015 2009 65225 39.4 21.8 19.15 1.3 11.5 17. including PCs.19 5470 -986 4484 2007 32479 34.6 36.9 39.0 57. complete.1 22.16 Price Volatility 199.7 25.0 24667. 2009 20956 .1 11.6 -11.3 1.3 -1.5 0.9 2008 18.0 18.13 1. 31640 .5 40. 4.4 13. 24327 .6 6.6 2004 13.0 .14 78. 13.5 12.9 27.89 289 -164 125 2003 8279 27.7 65.99 0.90 475. 4223 .0 4409 18. 2011 Fiscal year-end: September Apple.6 .68 12.5 . Data as originally reported.09 6. otherwise most recent annual data shown.9 .0 22.0 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 % +/.4 1. .3 120.5 2002 1.0 3.8 22.6 66.9 11. 6. you may use this report only in the country in which its original distributor is based. 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 15.8 .2 4.1 .5 1.3 15.9 53.35 4. 16.2 0.4 0.2 8.3 16.1 22.1 25382 29. 6.4 -25 -0.5 1.00 889 19.6 29.235.09 0. 3. Unless otherwise provided in a separate agreement.7 .8 . Inc.2 30.7 38. the iPhone. Redistribution is prohibited without written permission.99 1.6 4.4 Inventory Turns 68.4 Mar 11 % of shares Most Recent Period Prior Year Period 3.2 40.5 14.0 3. .Market Profitability Analysis Grade: A 52.3 9.8 35.1 9.0 Jun 10 Sep 10 Dec 10 Mar 11 Apple.06 1.3 1. 2005 8038 .1 .451 Last Price Fair Value 301. 0.4 10.0 56.36 34.0 Return on Assets % 25.9 276 0.00 878 13.7 10. and should not be considered a solicitation to buy or sell any security. The information contained herein is not represented or warranted to be accurate.8 0. .3 21. 72901 173427 2006 2007 -56. 7466 .7 Sep 10 70.1 29.7 2006 16. TTM data based on rolling quarterly data if available.27 0. and the iPod. 25893 2004 123.5 12.0 21.0 -344 -6.5 Price/Earnings P/E vs. TTM Working Capital USD Mil Long-Term Debt USD Mil Total Equity USD Mil Debt/Equity Valuation 36.0 19. call +1 312-696-6869.4 8235 9.51 6.6 2005 13.9 32.3 11.5 19. 2.1 29.56 7.3 7.2 62.2 60.7 11.

If we think a stock’s fair value is $50. Although you might expect to see more 5-star stocks as the market rises. © 2011 Morningstar. relatively few will receive our highest rating of 5 stars. with 5 the best and 1 the worst. and should not be considered a solicitation to buy or sell any security. We calculate our star ratings nightly after the markets close. you may use this report only in the country in which its original distributor is based. not as pieces of paper. which is why the rating date on our reports will always be the previous business day.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. Data as originally reported. we monitor market events and all of our stocks every business day. distributor. we evaluate stocks as pieces of a business. but the shares are more attractive as an investment at $40 than they were at $50. ß ® . we find assets more attractive when they’re cheap. When stocks are high. To order reprints. no matter how wonderful we think the business is. DCF model leads to the firm’s Fair Value Estimate. Analyst conducts company and industry research: Management interviews Conference calls Trade-show visits Competitor. so our ratings always reflect our analyst’s current opinion. Our fair value estimates don’t change very often. a stock may gain or lose stars based just on movement in the share price. or timely. Of course. 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 the shares decline to $40 without much change in the value of the business. Our estimate of what the business is worth hasn’t changed. correct. many more will likely garner 5 stars. To license the research. Assumptions are input into a discounted cash-flow model. usually by virtue of some competitive advantage. adjusted for uncertainty. complete. 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. Redistribution is prohibited without written permission. for a simple reason: We have more confidence in our cash-flow forecasts for strong companies. usually about once or twice per quarter. at times we may appear out of step with the overall stock market. If a stock’s market price is significantly above our fair value estimate. the star rating will go up. we require a smaller discount than for mediocre ones. and issue them the following business day. Cash generated next year is worth more than cash generated several years down the road. The information contained herein is not represented or warranted to be accurate. determines the rating. rather than short-term movements in stock prices. We rate stocks 1 through 5 stars. So. Our star rating is based on our analyst’s estimate of how much a company’s business is worth per share. and thus in our value estimates. and then adjusting the total for timing and risk. which anchors the rating framework. For high-quality businesses. call +1 312-696-6869. 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. supplier. Because we focus on the long-term value of businesses. Even the best company is a bad deal if an investor overpays for its shares. Unless otherwise provided in a separate agreement. We update the text of our reports as new information becomes available. An uncertainty assessment establishes the margin of safety required for the stock rating. 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. it will receive a low star rating. 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. call +1 312-696-6100. This report is for information purposes only. That is why you’ll see two dates on every Morningstar stock report. But when the market tumbles. Stocks trading at meaningful discounts to our fair value estimates will receive high star ratings. All Rights Reserved. but market prices do. and cash from a stable and consistently profitable business is worth more than cash from a cyclical or unsteady business.

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