?

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 Apples 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 companys second-quarter results. Revenue increased 83%, driven by 126% iPhone revenue growth, 32% Mac revenue growth, $2.8 billion of iPad sales (there isnt 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. Weve 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 years 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 Apples 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 Apples 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 Apples 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 Apples experience in developing handheld electronics, software design, and media distribution. We think the iPhone cemented Apples 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

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 .

Close Competitors Apple, Inc. Microsoft Corporation Hewlett-Packard Company Dell, Inc.

Currency(Mil) USD USD USD USD

Market Cap 301,378 199,899 73,114 29,185

TTM Sales 87,451 68,615 127,941 61,637

Oper Income 25,382 26,920 11,980 4,126

Net Income 19,552 21,794 9,220 3,239

easy for consumers to install applications and to keep their applications library up to date with one click. We therefore believe the Mac App Store has the potential to drive further market share gains. Despite a full decade of continuous successes under its belt, there is still the potential for things to go wrong at Apple. While we believe the network effects and modest switching costs are partially responsible for Apples continued revenue growth and expanding profitability, we think the intangibles associated with the Apple brand are just as important to the companys ongoing success. Anything that tarnishes the brand could quickly undo what it took the past decade to achieve. This is why we think investors are right to be concerned about the potential for Steve Jobs permanent departure from Apple. Although Apple has an abundance of talented developers, engineers, product managers, and marketers, we think Jobs leadership has been instrumental to pull those people together and prevent any truly bad products from making it out the door.

Morningstar data as of June 10, 2011.

strong network effect, as the vast number of iPhones in customers hands has created a massive market for third-party applications, which has enticed a massive number of developers to create applications for iOS, which in turn increases the appeal of the iOS platform for consumers. Additionally, as consumers invest more money in iOS applications and media from the iTunes Store, switching costs will grow. Apple is already leveraging the success of the iPhone with the launch of the iPad, which by some estimates accounts for more than 80% of the nascent tablet computing market. Although Apples desktop and notebook revenue is now only two thirds the size of iPhone revenue, it is important to recognize that revenue from those products has been steadily growing--from $7.4 billion in 2006 to $17.5 billion in 2010--despite the fact that the iPod, iPhone, and iPad work in conjunction with Windows-based computers as well. Apple has steadily gained share in the notebook and desktop market throughout the past decade, and we think the launch of the Mac App Store could accelerate market share increases. The biggest legitimate knock against Apples PCs, in our view, is that the availability of third-party applications has been extremely limited compared with Windows. This was exacerbated by the fact that third-party software produced for the Mac got extremely limited retail distribution. With the Mac App Store, Apple can now distribute third-party applications directly to consumers. Moreover, it makes it easy for consumers to review applications (thus making it less risky to try new applications) and makes it extremely

Valuation, Growth and Profitability

We are increasing our fair value estimate to $475 per share from $460. Most of this increase is due to higher expectations for iPad sales after the strong U.S. and international launches of the iPad 2, but weve also increased our expectation for PC sales. 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. Weve also modeled more rapid market share gains in Apples legacy desktop and notebook computer businesses. We still expect Apples share of the smartphone market to top out at around 15% by 2015.

2011 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported.
The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

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 .

We believe the iPod business will contract at a 10% per year on volume, 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. However, we still think iPods will have a place in the iOS ecosystem. As we believe the iPad will remain very successful and will drive increased sales of high-margin applications and media, weve boosted our long-term gross margin target to 42.5% from 40%. We dont expect a significant change in the firms cost structure, so we think operating margins will hit north of 30%.

software puts iOS at less risk than Android, which runs the risk of fragmentation. With less than 5% share worldwide, the Mac computer can continue to increase its share as a capable Windows alternative. We think the Mac App Store will accelerate share gains. Apples retail stores provide a platform for exposing new consumers to the breadth of the companys expanding product line. We continue to be surprised at the number of first-time Mac customers the firm adds every year.

Bears Say Risk

In our view, Apples success during the past decade is largely attributable to the leadership of Steve Jobs, and his long-term absence could deal a heavy blow to the company. We think COO Tim Cook is an able manager and Apple has an extremely deep talent pool. But we also believe Jobs product- and user-focused vision has been instrumental to Apples renaissance and has served investors incredibly well. If Jobs were to leave the firm on a permanent basis, we would expect a couple of years of smooth sailing, but wed worry about how long Apples winning streak could continue after that. The other major risk for shareholders is the firms heavy dependence on U.S. consumers and high-priced products. A downturn in the U.S. economy, or a worldwide economic downturn, would probably weigh on sales growth, as it did in fiscal 2009.

Apples sales are concentrated in the U.S., exposing the firm to significant customer concentration risk in the event of a big economic downturn. Although it has a significant international presence, the high price points of its products could limit growth in emerging markets. Nearly 40% of Apples revenue comes from the iPhone line, and our valuation assumes that the iPad becomes a significant growth driver. If either the iPhone or iPad disappoints, our fair value estimate will fall. Steve Jobs recurring health problems are a legitimate concern. We think he deserves much of the credit for Apples tremendous success during the past decade. While we think Apple has an economic moat, much of its ability to open customers wallets is based on its brand image. We think this image is deserved, since the firm has gone a full decade without a significant flop. But if the brand becomes tarnished, all bets are off.

Financial Overview Bulls Say

The iOS mobile operating system is likely to be part of a duopoly with Googles Android, but we think that Apples integrated control of both hardware and

Financial Health: The company has $26 billion in cash and short-term investments, holds another $25 billion in long-term investments, and has generated $16.5 billion in free cash flows in fiscal 2010. It carries no debt.

2011 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported.
The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

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 .

Company Overview

Profile: Apple designs consumer electronic devices, including PCs, the iPad, the iPhone, and the iPod. Its iTunes online store is the largest music distributor in the world; it sells and rents TV shows and movies and sells applications for the iPhone and iPad. In early 2011, Apple launched the Mac App Store, an online store that sells first- and third-party applications for the Mac line of desktop and notebook computers. Apples products are distributed online as well as through company-owned stores and third-party retailers. Management: Steve Jobs cofounded Apple in 1976 and rejoined the company as CEO in 1997. Jobs health is a significant concern, 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. He has personally recruited much of the current management team, and most have worked with him for a long time. COO Tim Cook came to Apple from Compaq in 1998. CFO Peter Oppenheimer has been with the company since 1996. Though the stock-option backdating scandal raises our stewardship concerns, we believe aggressive moves by the board have enabled the company to turn the page. Apple has taken other steps in the right direction, including the appointment of lead codirectors in 2006. The majority of executive compensation is aligned with shareholder interests in the form of restricted stock units tied to long-term company performance. As such, Apples executives have been richly rewarded as a result of the companys tremendous performance, but the vast majority of compensation comes from equity as opposed to cash.

2011 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported.
The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

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 .

Analyst Notes
Apr. 20, 2011 First Take on Apples 2Q--Blowout. Operating Income Up 98% off of 83% Revenue Growth.

We are sticking with our $475 fair value estimate for Apple after reviewing the companys second-quarter results. Revenue increased 83%, driven by 126% iPhone revenue growth, 32% Mac revenue growth, $2.8 billion of iPad sales (there isnt 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
Jan. 18, 2011 Apple Under Review

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. Weve 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 years 9% and 3.2%. Put gross margins and operating expenses together and operating margins rose to 31.9% from 29.5% in the year-ago quarter.

We are putting our fair value estimate for Apple under review while we transition coverage of the company to a different analyst. Steve Jobs second leave of absence is certainly a matter of concern, as we view his leadership as

an important factor in the firms success over the past decade. We think Apple can function perfectly well in the near to intermediate term in his absence, but if he were to hand over leadership on a permanent basis, wed have to reassess our long-term view.

Disclaimers & Disclosures No Morningstar employees are officers or directors of this company. Morningstar Inc. does not own more than 1% of the shares of this company. Analysts covering this company do not own its stock. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.

2011 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported.
The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

Morningstar Stock Data Sheet

Pricing data thru Jun. 10, 2011

Rating updated as of Jun. 10, 2011

Fiscal year-end: September

Apple, Inc. AAPL

Apple designs consumer electronic devices, including PCs, the iPad, the iPhone, and the iPod. Its iTunes online store is the largest music distributor in the world; it sells and rents TV shows and movies and sells applications for the iPhone and iPad. In early 2011, Apple launched the Mac App Store, an online store that sells first- and third-party applications for the Mac line of desktop and notebook computers. Apples products are distributed online as well as through company-owned stores and third-party retailers.
Morningstar Rating

Sales USD Mil Mkt Cap USD Mil Industry

Sector

87,451
Last Price Fair Value

301,378
Uncertainty

Computer Systems
Economic Moat
TM

Technology
Stewardship Grade

QQQQQ
13.56 7.22

325.90

475.00 75.46 31.30

2:1

Medium

Narrow

B per share prices in USD

Annual Price High Low Recent Splits

13.09 6.68

12.51 6.36

34.78 10.59

93.16 202.96 200.26 213.95 326.66 364.90 50.25 81.90 79.14 78.20 190.25 320.16

Price Volatility
199.0 59.0 19.0

Monthly High/Low Rel Strength to S&P 500 52 week High/Low 364.90 - 235.56 10 Year High/Low 364.90 - 6.36 Bear-Market Rank 6 (10=worst) Trading Volume Million

1 Infinite Loop Cupertino, CA 95014 Phone: 1 408 996-1010Website: http://www.apple.com

6.0 1.0 39.0 19.0

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 % +/- Market +/- Industry Dividend Yield % Market Cap USD Mil
Financials

Revenue % Operating Income % Earnings/Share % Dividends % Book Value/Share % Stock Total Return % +/- Industry +/- Market Profitability Analysis
Grade: A

52.0 56.6 66.8 . 48.4 30.1 29.5 12.0

Current

39.5 61.0 56.8 . 46.2 20.6 12.1 22.5

5 Yr Avg

36.2 62.0 57.6 . 42.1 40.6 29.2 40.1

Ind

23.4 42.8 30.1 . 23.7 42.6 36.9 41.9

Mkt

47.2 60.2 46.8 . 7703

2001

-34.6 -11.2 -34.8 . 5146

2002

49.1 22.7 48.3 . 7859

2003

201.4 192.4 200.9 . 25893

2004

123.3 120.3 122.8 . 60587

2005

18.0 133.5 4.4 130.0 17.4 101.4 . . 72901 173427

2006 2007

-56.9 146.9 53.1 1.0 -18.4 123.5 40.3 -1.1 -84.1 146.4 52.5 0.7 0.0 . . . 75997 190983 297089 301378
2008 2009 2010 TTM

5363 23.0 -344 -6.4 -25 -0.04 0.00 691 5.64 185 -232 -47
2001

5742 27.9 17 0.3 65 0.09 0.00 724 5.73 89 -174 -85

2002

6207 27.5 -1 0 69 0.10 0.00 727 5.89 289 -164 125

2003

8279 27.3 326 3.9 276 0.36 0.00 775 7.20 934 -176 758
2004

13931 29.0 1650 11.8 1335 1.56 0.00 857 9.94 2535 -260 2275
2005

19315 29.0 2453 12.7 1989 2.27 0.00 878 13.07 2220 -657 1563
2006

24006 34.0 4409 18.4 3496 3.93 0.00 889 19.19 5470 -986 4484
2007

32479 34.3 6275 19.3 4834 5.36 0.00 902 25.73 9596 -1199 8397
2008

42905 40.1 11740 27.4 8235 9.08 0.00 907 39.47 10159 -1144 9015
2009

65225 39.4 18385 28.2 14013 15.15 0.00 925 52.10 18595 -2005 16590
2010

87451 39.1 25382 29.0 19552 20.99 0.00 931 66.48 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 % 38.8 29.0 Return on Assets % 25.7 17.4 Fixed Asset Turns 17.9 16.4 Inventory Turns 68.0 54.0 Revenue/Employee USD K1770.3 1137.2 * Gross Margin % Operating Margin % Net Margin % Free Cash Flow/Rev % R&D/Rev % Financial Position
Grade: A 09-10 USD Mil

35.5 12.7 11.3 20.6 . 32.5 12.1 11.6 12.7 .

23.2 8.8 7.3 14.7 956.4 39.3 15.4 10.4 0.1 9.9

39.1 29.0 22.4 26.6 2.4

35.4 21.2 16.1 19.8 0.0

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 . 20722 . 27392 47791
5 Yr Avg Ind

15978 930 11095 46997 6241 1248 94904 14645 . 24327 . 33427 61477
Mkt

-0.4 -0.6 -0.5 0.84 1.5

2001

1.1 1.6 1.1 0.93 1.5

2002

1.1 1.7 1.1 0.95 1.6

2003

3.7 5.9 3.3 1.11 1.6

2004

13.6 21.3 9.6 1.42 1.6

2005

13.8 22.8 10.3 1.34 1.7

2006

16.4 28.5 14.6 1.13 1.7

2007

14.9 27.2 14.9 1.00 1.9

2008

18.9 31.3 19.2 0.99 1.5

2009

22.8 35.3 21.5 1.06 1.6

2010

25.7 38.8 22.4 1.15 1.5

03-11

Return on Assets % Return on Equity % Net Margin % Asset Turnover Financial Leverage
Financial Health

3625 317 3920 0.08

2001

3730 316 4095 0.08

2002

3530 . 4223 .
2003

4375 . 5076 .
2004

6816 . 7466 .
2005

8038 . 9984 .
2006

12657 . 14532 .
2007

20598 . 21030 .
2008

20049 . 31640 .
2009

20956 . 47791 .
2010

22670 . 61477 .
TTM

Working Capital USD Mil Long-Term Debt USD Mil Total Equity USD Mil Debt/Equity
Valuation

36.9 . 1.3 1.9 32.0

. . 0.9 1.3 33.0

57.1 . 1.2 1.8 19.7

50.5 . 2.6 4.5 17.2

38.8 . 3.8 7.2 30.1

30.8 . 3.6 6.5 19.8

43.5 . 6.7 10.3 27.5

15.9 . 2.3 3.3 7.2

20.5 . 4.1 5.3 16.0

18.0 1.0 3.9 5.4 13.3

15.5 1.0 3.5 4.9 11.5

Price/Earnings P/E vs. 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

15.5 11.3 11.5 13.0 . 4.9 3.5 0.7

25.7 . 16.8 19.8 . 6.2 4.1 .

13.3 . 9.8 11.9 0.6 4.5 1.6 .

14.9 13.0 8.5 17.3 1.9 2.0 1.3 1.5

Most Recent Period Prior Year Period

Rev Growth %

15700.0 20343.0 26741.0 24667.0 8337.0 16238.0 15683.0 13499.0

Jun 10 Sep 10 Dec 10 Mar 11

Apple, Inc. Microsoft Corporatio Hewlett-Packard Comp Major Fund Holders

301378 199899 73114

87451 15.5 68615 9.4 127941 8.7

38.8 44.0 21.7

Most Recent Period Prior Year Period

Earnings Per Share USD

88.3 11.7
Jun 10

25.3 105.7
Sep 10

70.5 54.3
Dec 10

82.7 65.4
Mar 11

% of shares

Most Recent Period Prior Year Period

3.51 1.35

4.64 4.61

6.43 3.67

6.40 3.33

. . .
TTM data based on rolling quarterly data if available; otherwise most recent annual data shown.

*3Yr Avg data is displayed in place of 5Yr Avg

2011 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported.

The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

Morningstars 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, we evaluate stocks as pieces of a business, not as pieces of paper. 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. We rate stocks 1 through 5 stars, with 5 the best and 1 the worst. Our star rating is based on our analysts estimate of how much a companys business is worth per share. 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, and then adjusting the total for timing and risk. Cash generated next year is worth more than cash generated several years down the road, and cash from a stable and consistently profitable business is worth more than cash from a cyclical or unsteady business. Stocks trading at meaningful discounts to our fair value estimates will receive high star ratings. For high-quality businesses, we require a smaller discount than for mediocre ones, for a simple reason: We have more confidence in our cash-flow forecasts for strong companies, and thus in our value estimates. If a stocks market price is significantly above our fair value estimate, it will receive a low star rating, no matter how wonderful we think the business is. Even the best company is a bad deal if an investor overpays for its shares. Our fair value estimates dont change very often, but market prices do. So, a stock may gain or lose stars based

just on movement in the share price. If we think a stocks fair value is $50, and the shares decline to $40 without much change in the value of the business, the star rating will go up. Our estimate of what the business is worth hasnt changed, but the shares are more attractive as an investment at $40 than they were at $50. Because we focus on the long-term value of businesses, rather than short-term movements in stock prices, at times we may appear out of step with the overall stock market. When stocks are high, relatively few will receive our highest rating of 5 stars. But when the market tumbles, many more will likely garner 5 stars. Although you might expect to see more 5-star stocks as the market rises, we find assets more attractive when theyre cheap. We calculate our star ratings nightly after the markets close, and issue them the following business day, which is why the rating date on our reports will always be the previous business day. We update the text of our reports as new information becomes available, usually about once or twice per quarter. That is why youll see two dates on every Morningstar stock report. Of course, we monitor market events and all of our stocks every business day, so our ratings always reflect our analysts current opinion.

Economic Moat Rating

TM

The Economic Moat Rating is our assessment of a firms ability to earn returns consistently above its cost of capital in the future, usually by virtue of some competitive advantage. 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, adjusted for uncertainty, determines the rating.

Analyst conducts company and industry research: Management interviews Conference calls Trade-show visits Competitor, supplier, distributor, and customer interviews

The depth of the firms competitive advantage is rated: None Narrow Wide

Analyst considers company financial statements and competitive position to forecast future cash flows. Assumptions are input into a discounted cash-flow model.

DCF model leads to the firms Fair Value Estimate, which anchors the rating framework.

An uncertainty assessment establishes the margin of safety required for the stock rating.

2011 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported.
The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.

Morningstars Approach to Rating Stocks (continued)

economic profits, but companies that can earn them for an extended time by creating a competitive advantage possess an Economic Moat. We see these companies as superior investments.

Very High, or Extreme. The greater the level of uncertainty, the greater the discount to fair value required before a stock can earn 5 stars, 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, subtracting the amount of cash that the company will need to reinvest in its business, and using the result to calculate the worth of the firm. We use this technique to value nearly all of the companies we cover.

This is the discount to fair value we would require before recommending a stock. We think its always prudent to buy stocks for less than theyre worth.The margin of safety is like an insurance policy that protects investors from bad news or overly optimistic fair value estimates. We require larger margins of safety for less predictable stocks, and smaller margins of safety for more predictable stocks.

Discount Rate

We use this number to adjust the value of our forecasted cash flows for the risk that they may not materialize. For a profitable company in a steady line of business, well use a lower discount rate, also known as "cost of capital," than for a firm in a cyclical business with fierce competition, since theres less risk clouding the firms future.

Consider Buying/Consider Selling

The consider buying price is the price at which a stock would be rated 5 stars, and thus the point at which we would consider the stock an extremely attractive purchase. Conversely, consider selling is the price at which a stock would have a 1 star rating, at which point wed consider the stock overvalued, with low expected returns relative to its risk.

Fair Value

This is the output of our discounted cash-flow valuation models, and is our per-share estimate of a companys intrinsic worth. We adjust our fair values for off-balance sheet liabilities or assets that a firm might have--for example, we deduct from a companys fair value if it has issued a lot of stock options or has an under-funded pension plan. Our fair value estimate differs from a "target price" in two ways. First, its an estimate of what the business is worth, whereas a price target typically reflects what other investors may pay for the stock. Second, its a long-term estimate, whereas price targets generally focus on the next two to 12 months.

Stewardship Grades

We evaluate the commitment to shareholders demonstrated by each firms board and management team by assessing transparency, shareholder friendliness, incentives, and ownership. We aim to identify firms that provide investors with insufficient or potentially misleading financial information, seek to limit the power of minority shareholders, allow management to abuse its position, or which have management incentives that are not aligned with the interests of long-term shareholders. The grades are assigned on an absolute scale--not relative to peers--and can be interpreted as follows: A means "Excellent," B means "Good," C means "Fair," D means "Poor," and F means "Very Poor."

Uncertainty

To generate the Morningstar Uncertainty Rating, analysts consider factors such as sales predictability, operating leverage, and financial leverage. Analysts then classify their ability to bound the fair value estimate for the stock into one of several uncertainty levels: Low, Medium, High,
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