How to Determine Whether a Stock Is Cheap, Expensive, or Fairly Valued

We believe that the surest way to create wealth in the stock market is to purchase shares of superior businesses and allow those businesses to compound value over long periods of time.

But no matter how good a company’s fundamentals are, its stock is more attractive when it’s cheap than when it’s expensive. In the same way you wait for a sale to get a good deal on clothes or a flat-screen TV, it’s also a good idea to wait to purchase stocks—even high-quality ones—when they’re trading at discounts.

The Morningstar Rating for stocks signals whether a stock is cheap, expensive, or fairly priced compared with what our analysts think it’s worth.

Three key components drive the rating:

• Our estimate of the stock’s fair value,
• Our uncertainty around the fair value estimate, and
• The current market price.

Here’s how we approach assigning this rating to stocks.

What Is the Morningstar Rating for Stocks?

The Morningstar Rating for stocks, also known as the “star rating,” is the product of two other Morningstar data points: the Morningstar Fair Value Estimate and the Morningstar Uncertainty Rating.

• The Morningstar Fair Value Estimate is an analyst’s estimate of a stock’s intrinsic value, or what a stock is worth in the long term. This estimate is driven by combining an analyst’s financial forecasts with the stock’s economic moat rating.
• The Morningstar Uncertainty Rating describes an analyst’s certainty about the future of the stock.

These two data points interact to produce the star rating, which uses a scale of 1-5 stars to communicate if a stock is considered cheap, expensive, or fairly priced.

Generally, stocks trading at large discounts to our analysts’ fair value estimates will receive higher (4 or 5) star ratings, and stocks trading at large premiums to their fair value estimates will receive lower (1 or 2) star ratings. Stocks that are trading at a price near our analysts’ fair value estimates will usually get 3-star ratings.

But not all companies are created equal: The star rating is also influenced by the Uncertainty Rating. If the future of a stock is very uncertain, the stock needs to be trading at a greater discount to its fair value estimate (that is, trading with a greater margin of safety) to justify a recommendation to buy. Conversely, the greater a premium it should be trading at to justify a recommendation to sell.

Here’s what each star rating means:

• 5 stars: We believe appreciation beyond a fair risk-adjusted return is highly likely over a multiyear time frame. Our analysis indicates that the current market price represents an excessively pessimistic outlook, which limits downside risk and maximizes upside potential.
• 4 stars: We believe appreciation beyond a fair risk-adjusted return is likely over a multiyear time frame.
• 3 stars: We believe investors are likely to receive a fair risk-adjusted return (approximately cost of equity).
• 2 stars: We believe investors are likely to receive a less than fair risk-adjusted return.
• 1 star: We believe there is a high probability of undesirable risk-adjusted returns from the current market price over a multiyear time frame. Our analysis indicates that the market is pricing in an excessively optimistic outlook, which limits upside potential and leaves the investor exposed to capital loss.

Let’s say a stock is valued at $100 and has low uncertainty. That means that the stock would be considered a:

• 1-star stock when trading at $125 or more (a 25% premium)
• 2-star stock when trading between $105 and $125 (a 5%-25% premium)
• 3-star stock when trading between $95 and $105 (right around its fair value)
• 4-star stock when trading between $80 and $95 (a 5%-20% discount)
• 5-star stock when trading at $80 or lower (at least a 20% discount)

Because the future of this imaginary stock doesn’t hold much uncertainty, the margin of safety required to justify a buy or sell recommendation is relatively small.

Now imagine this stock valued at $100 has Extreme Uncertainty. This stock would need to reach a much lower price point to justify a recommended buy and a much higher price point to justify a recommended sell. That means it would be a:

• 1-star stock when trading at $400 or more (a 400% premium)
• 2-star stock when trading between $200 and $400 (a 200%-400% premium)
• 3-star stock when trading between $50 and $200 (right around its fair value)
• 4-star stock when trading between $25 and $50 (a 50%-75% discount)
• 5-star stock when trading at $25 or lower (at least a 75% discount)

A stock’s star rating is recalculated at market close every day. While the Uncertainty Rating and fair value estimate don’t necessarily change daily, the stock price does. So, we ensure that the star rating reflects how that most recent stock price aligns with our other metrics.

That said, there is no predefined distribution of stars—the number of stocks that earn 5 stars can and will fluctuate daily, so the total number of 5- and 1-star ratings on the books can help you gauge the broader market’s valuation.

So, when the market is soaring and stocks are richly valued, relatively few will receive the highest Morningstar Rating of 5 stars. But when the market tumbles, there will be many more 5-star stocks as deals abound.

When to Consider Buying and When to Consider Selling

What do these stars mean for your buy and sell decisions? They tell you price points at which you should “consider buying” and “consider selling.”

The stock price that triggers a 5-star rating is its “consider buying” price, while the stock price that triggers a 1-star rating is its “consider selling” price.

For an example of a stock with Low Uncertainty, let’s consider General Dynamics GD. As of Sept. 25, 2024, General Dynamics has a fair value estimate of $300. The Low Uncertainty Rating means it would need to be trading at a 25% premium ($375) to trigger a 1-star rating and a 20% discount ($240) to trigger a 5-star rating.

Now consider a stock with High Uncertainty, such as LPL Financial Holdings LPLA. As of Sept. 25, 2024, LPL’s fair value estimate is $311. That’s a similar fair value estimate to General Dynamics, but because of the increased level of uncertainty associated with the stock, it must reach a much higher price point to “consider selling” and a lower price point to “consider buying.” LPL would see a 1-star rating when trading at a 55% premium ($482.05), while it would see a 5-star rating if it traded at a 40% discount ($186.60).

How to Use the Morningstar Rating for Stocks

A stock’s fair value estimate and Uncertainty Rating have longer shelf lives, while the star rating can change frequently as a stock price fluctuates.

If you find that a seemingly high-quality company has a low star rating, it’s not necessarily because we’ve lost faith in the company itself—it’s because it’s trading at a higher price than it’s worth. No matter how great that expensive flat-screen TV may be, it doesn’t mean you should accept any price set on it.

In other words, it’s important to remember that the purpose of the Morningstar Rating for stocks isn’t to communicate which companies are the best at this moment. The purpose is to communicate which companies are the best to buy at this moment.

This article includes updated content that originally appeared in Morningstar’s stock investing course, which was distributed by The Professional Education Institute.