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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

While we believe the network effects and modest switching costs are partially responsible for Apple’s continued revenue growth and expanding profitability. correct. We therefore believe the Mac App Store has the potential to drive further market share gains. This report is for information purposes only. complete. Currency(Mil) USD USD USD USD Market Cap 301. or timely. engineers.451 68.239 easy for consumers to install applications and to keep their applications library up to date with one click. Apple has steadily gained share in the notebook and desktop market throughout the past decade. as consumers invest more money in iOS applications and media from the iTunes Store. which has enticed a massive number of developers to create applications for iOS. Microsoft Corporation Hewlett-Packard Company Dell.90 USD Fair Value 475. we think the intangibles associated with the Apple brand are just as important to the company’s ongoing success. We still expect Apple’s share of the smartphone market to top out at around 15% by 2015. We’ve also modeled more rapid market share gains in Apple’s legacy desktop and notebook computer businesses.980 4.220 3. Apple is already leveraging the success of the iPhone with the launch of the iPad. product managers. you may use this report only in the country in which its original distributor is based. Additionally.378 199.941 61.382 26. This was exacerbated by the fact that third-party software produced for the Mac got extremely limited retail distribution. ß ® . This is why we think investors are right to be concerned about the potential for Steve Jobs’ permanent departure from Apple.S. there is still the potential for things to go wrong at Apple. Although Apple has an abundance of talented developers. To license the research. switching costs will grow.637 Oper Income 25. Inc.Apple. it is important to recognize that revenue from those products has been steadily growing--from $7.114 29.4 billion in 2006 to $17. Apple can now distribute third-party applications directly to consumers.185 TTM Sales 87.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems .50 USD [Nasdaq] Consider Sell 665. 2011. AAPL Last Price 325. and we think the launch of the Mac App Store could accelerate market share increases. Close Competitors Apple. Although Apple’s desktop and notebook revenue is now only two thirds the size of iPhone revenue. and should not be considered a solicitation to buy or sell any security. Morningstar data as of June 10.5 billion in 2010--despite the fact that the iPod. The information contained herein is not represented or warranted to be accurate. and marketers. call +1 312-696-6869. © 2011 Morningstar. but we’ve also increased our expectation for PC sales. 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 international launches of the iPad 2. Growth and Profitability We are increasing our fair value estimate to $475 per share from $460. To order reprints. Inc. Data as originally reported. 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 2015.920 11. as the vast number of iPhones in customers’ hands has created a massive market for third-party applications. which by some estimates accounts for more than 80% of the nascent tablet computing market.615 127. Despite a full decade of continuous successes under its belt. Redistribution is prohibited without written permission. is that the availability of third-party applications has been extremely limited compared with Windows. call +1 312-696-6100. iPhone. which in turn increases the appeal of the iOS platform for consumers.899 73. Unless otherwise provided in a separate agreement. With the Mac App Store. Most of this increase is due to higher expectations for iPad sales after the strong U. All Rights Reserved.794 9.552 21.00 USD Consider Buy 332. Moreover. The biggest legitimate knock against Apple’s PCs. in our view. Inc. it makes it easy for consumers to review applications (thus making it less risky to try new applications) and makes it extremely Valuation. and iPad work in conjunction with Windows-based computers as well.126 Net Income 19. strong network effect. Anything that tarnishes the brand could quickly undo what it took the past decade to achieve.

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

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

iPad. We are sticking with our $475 fair value estimate for Apple after reviewing the company’s second-quarter results. respectively. to 41.8 billion of iPad sales (there isn’t a year-over-year growth figure because the iPad was released later in 2010).4% from 41. To order reprints.50 USD [Nasdaq] Consider Sell 665. or timely. which is being cannibalized by the iPhone). this was much slower than the revenue growth of 93% for the the combination of iPod.2%. This report is for information purposes only. correct. Given that we think software and iTunes have significantly higher gross margins than hardware. Apple actually saw a small amount of gross margin contraction. those figures numbers were 7. driven by 126% iPhone revenue growth. All Rights Reserved. respectively. Put gross margins and operating expenses together and operating margins rose to 31. 23% in iTunes revenue. Unless otherwise provided in a separate agreement. Our investment thesis has been that the firm would see broad-based growth across its entire product portfolio (excepting the iPod. One area in which our thesis appeared at first to not quite hold up this quarter was on the gross margin line. and Macs. but the overall gross margin decline was from the mix shift. call +1 312-696-6100. 32% Mac revenue growth. 2011 Apple Under Review revenue grew an impressive 17% and 23%.5% in the year-ago quarter.Apple. and 23% growth in revenue from peripherals. © 2011 Morningstar. We’ve been modeling long-term selling. 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. we’d have to reassess our long-term view. $2.4%. Revenue increased 83%. and R&D at 3%-3. Disclaimers & Disclosures No Morningstar employees are officers or directors of this company. Inc. These represent a significant improvement over the prior year’s 9% and 3. AAPL Last Price 325. complete.1% and 2. iPhone. and should not be considered a solicitation to buy or sell any security. ß ® . and administrative expenses at about 8% of sales. To license the research. 17% growth in software sales. does not own more than 1% of the shares of this company. Analyst Notes Apr. Data as originally reported. 20. In the second quarter. This report is for information purposes only. call +1 312-696-6869. Analysts covering this company do not own its stock.5% of sales.7% in the year-ago quarter. 2011 First Take on Apple’s 2Q--Blowout. Morningstar Inc. it is important to note that although software and iTunes Jan. The information contained herein is not represented or warranted to be accurate.9% from 29. We are putting our fair value estimate for Apple under review while we transition coverage of the company to a different analyst. complete. or timely. Operating Income Up 98% off of 83% Revenue Growth. This growth was partially offset by a 14% decline in iPod revenue. hardware peripherals. correct. We think Apple can function perfectly well in the near to intermediate term in his absence.90 USD Fair Value 475. you may use this report only in the country in which its original distributor is based. based on second-quarter results we think our thesis remains intact. general. our guess is that gross margins improved for most (if not all) categories. Redistribution is prohibited without written permission. However. The information contained herein is not represented or warranted to be accurate. and should not be considered a solicitation to buy or sell any security. but if he were to hand over leadership on a permanent basis.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems .00 USD Consider Buy 332. 18. Apple also beat our expectations on operating expenses.

3 65 0.6 6.4 123.6.1 146.4 21.0 Monthly High/Low Rel Strength to S&P 500 52 week High/Low 364.0 . To order reprints.0 18.4 Mar 11 % of shares Most Recent Period Prior Year Period 3.0 8337.1 19. call +1 312-696-6100.64 185 -232 -47 2001 5742 27. 2003 4375 . 61477 .1 29.36 34.1 5. To license the research.3 Dec 10 82. 3. 3. call +1 312-696-6869.0 19552 20.3 33. CA 95014 Phone: 1 408 996-1010Website: http://www. including PCs.4 52.73 89 -174 -85 2002 6207 27.9 Mkt 47.00 878 13.Industry Dividend Yield % Market Cap USD Mil Financials Revenue % Operating Income % Earnings/Share % Dividends % Book Value/Share % Stock Total Return % +/. 46.2 * Gross Margin % Operating Margin % Net Margin % Free Cash Flow/Rev % R&D/Rev % Financial Position Grade: A 09-10 USD Mil 35.5 19.40 3.56 0.00 691 5.7 11. 72901 173427 2006 2007 -56. Redistribution is prohibited without written permission.7 50.9 53. 2004 6816 . .6 1. 6.7 42.20 934 -176 758 2004 13931 29.6 -0.3 122.2 0.61 6.00 889 19.9 1.1 Ind 23.35 4.8 . *3Yr Avg data is displayed in place of 5Yr Avg © 2011 Morningstar. Unless otherwise provided in a separate agreement.3 . .8 10.2 -34.4 0.00 907 39. 6.7 65.0 22.2 20.51 6. the iPad.0 56.9 32.7 1989 2.3 1.9 3. 2011 Rating updated as of Jun.5 54.6 -11.5 15.1 22.08 2001 3730 316 4095 0. 4.9 17 0. 4. 2009 20956 .1 .0 13499.1 -84.7 2006 16.3 11.1 1.8 7.8 .6 . 14532 . Microsoft Corporatio Hewlett-Packard Comp Major Fund Holders 301378 199899 73114 87451 15.04 0.4 101.6 29. . 2.9 31.43 3.8 .93 0.95 1.6 2. 7466 .3 1. Its iTunes online store is the largest music distributor in the world.4 35.451 Last Price Fair Value 301.94 2535 -260 2275 2005 19315 29.8 11.3 1. Inc.9 16.8 7. 2006 12657 .4 Fixed Asset Turns 17.99 1.15 1.2 4.2 46.5 5 Yr Avg 36.7 38.5 .93 1.8 35.9 2008 18.5 1.42 1.0 Revenue/Employee USD K1770.90 50.0 56.26 213.apple.5 Price/Earnings P/E vs.8 0.7 38. TTM data based on rolling quarterly data if available.7 Sep 10 70.59 93.5 12.Market +/.0 57.3 15. and the iPod.0 .0 16238.5 2001 1. ß ® .1 9.2 14.0 1.2 38.36 0.96 200. 10.4 Inventory Turns 68.6 21.6 4. 60587 2005 18.5 Most Recent Period Prior Year Period Rev Growth % 15700.0 19. 0.6 2003 3.4 8235 9.2 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. Data as originally reported.8 .0 8. Apple launched the Mac App Store.7 0. .6 4.5 13.8 19.08 0. .3 3.9 2.0 -18.0 Return on Assets % 25. 2011 Fiscal year-end: September Apple.Morningstar ® Stock Data Sheet Pricing data thru Jun.00 1.6 .1 .90 475.1 30.2 60.0 3. 25893 2004 123.235. This report is for information purposes only.0 2453 12.9 0.0 4409 18.09 6.4 30.5 4. TTM Working Capital USD Mil Long-Term Debt USD Mil Total Equity USD Mil Debt/Equity Valuation 36.2 8.6 1.7 .78 10.6 1.0 26741. or timely.6 2010 25.95 326.4 10. you may use this report only in the country in which its original distributor is based.3 .9 27.7 1.3 20.9 13.3 120. 24327 . 7703 2001 -34.8 22.5 1.8 1335 1. 13.9 5.7 10.5 2002 1. 5146 2002 49.1 1. 27392 47791 5 Yr Avg Ind 15978 930 11095 46997 6241 1248 94904 14645 . 23.0 -344 -6.8 . In early 2011. 9984 . AAPL Apple designs consumer electronic devices.1 11.84 1.0 .34 1.1 0. 48.7 956.06 1.7 5.99 0. Inc. 75997 190983 297089 301378 2008 2009 2010 TTM 5363 23.5 .00 75.19 5470 -986 4484 2007 32479 34.16 202. 16. the iPhone.3 11.56 10 Year High/Low 364.2 62.0 1. 47791 .7 2007 14. Apple’s products are distributed online as well as through company-owned stores and third-party retailers.4 26.16 Price Volatility 199.8 .3 14.15 0. 7859 2003 201.2 40.56 7.3 326 3.and third-party applications for the Mac line of desktop and notebook computers.3 19.5 17.1 0.4 192.0 3.9 146.10 0. 5076 .14 78. 4223 . it sells and rents TV shows and movies and sells applications for the iPhone and iPad.00 727 5. 14.3 -1. 2008 20049 .3 6275 19. and should not be considered a solicitation to buy or sell any security.3 1.0 19.25 320.10 18595 -2005 16590 2010 87451 39. correct.0 20343.4 13.Industry +/.3 1.25 81.4 130.5 4.6 66. 9.64 4.8 43.7 17.2 14013 15.9 11.5 0.90 .5 40. 42.73 9596 -1199 8397 2008 42905 40. 2005 8038 . 32.5 14. 2.8 22.7 Most Recent Period Prior Year Period Earnings Per Share USD 88.0 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 % +/.5 12.0 Current 39.3 105.0 57.0 15683.4 1.8 44. 10.0 59. 31640 . Morningstar Rating Sales USD Mil Mkt Cap USD Mil Industry Sector 87.8 30.36 0.22 325. an online store that sells first.3 7. otherwise most recent annual data shown.7 48.0 133.5 17.36 Bear-Market Rank 6 (10=worst) Trading Volume Million 1 Infinite Loop Cupertino.00 857 9.46 31.6 . 33427 61477 Mkt -0.5 .4 42.08 2002 3530 .0 1650 11.0 24667.00 925 52.5 0.5 -1 0 69 0.3 27.3 16.com 6.5 12.5 2009 22. 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 15.6 2004 13.1 11740 27.9 3.4 127941 8.8 .09 0.90 79.4 28.5 1.Market Profitability Analysis Grade: A 52.3 9.4 18385 28. 2007 20598 .00 931 66.4 200.1 40.5 61.5 11. 1.00 724 5.9 .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 .8 .66 364. .47 10159 -1144 9015 2009 65225 39.8 19.7 Jun 10 25. 1.6 12.9 276 0.33 .9 1.11 1.1 25382 29.89 289 -164 125 2003 8279 27.9 .9 39.3 21.7 .4 -0.378 Uncertainty Computer Systems Economic Moat TM Technology Stewardship Grade QQQQQ 13.0 21. All Rights Reserved.00 775 7.6 2005 13.0 Jun 10 Sep 10 Dec 10 Mar 11 Apple.68 12.27 0.0 17. 21030 . 23.1 22.4 -25 -0.0 1.13 1.0 54.67 6.3 1137.0 39.6 12.3 4834 5.07 2220 -657 1563 2006 24006 34. 2010 22670 .2 20.2 16.30 2:1 Medium Narrow B per share prices in USD Annual Price High Low Recent Splits 13.5 68615 9.1 1.7 25.9 41. The information contained herein is not represented or warranted to be accurate.1 .4 39.90 .5 0.1 29.5 03-11 Return on Assets % Return on Equity % Net Margin % Asset Turnover Financial Leverage Financial Health 3625 317 3920 0.3 15.51 1.2 30.6 36.4 . complete.20 190. 20722 .9 .8 29.00 902 25.4 3496 3.

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

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