How to Measure a Stock’s Uncertainty

If a company is facing a lot of future uncertainty due to sales unpredictability, a rapidly evolving industry, or other factors, it makes sense that you’d want to get a better deal on the stock to account for that uncertainty.

That means that the price at which you can consider a stock a “good deal” doesn’t only depend on its fair value estimate, but also on the risks facing the stock—and you should look to earn a return that adequately compensates you for those risks.

So how big of a discount should you be looking for?

We use the Morningstar Uncertainty Rating to capture this. This rating describes how much uncertainty is facing a company, and therefore how much of a discount to fair value a company should be trading at before you consider buying.

What Is the Uncertainty Rating?

Morningstar classifies a company’s Uncertainty Rating as Low, Medium, High, Very High, or Extreme. Each rating band captures the range of prices, relative to fair value, that would justify selling or buying a stock.

What factors influence a company’s Uncertainty Rating? Pretty much anything that could increase the potential dispersion of future outcomes for the intrinsic value of a company, and anything that can affect our ability to accurately predict these outcomes.

That could be:

1. Predictability of sales. We may look at how much sales might vary across cycles and across different upside and downside scenarios. The larger the difference, the greater the uncertainty.
2. Operating leverage. We can look at how a change in sales translates into a change in operating profits. Companies with high fixed costs have greater operating leverage and therefore greater uncertainty.
3. Financial leverage. For equity investors, debt magnifies both the successes and failures of a company.
4. Contingent events. Is a company party to a large lawsuit? Is there some other event (licensing milestone, product launch, and so on) that could materially alter the intrinsic value of a company?

Take a company like ChargePoint CHPT, which provides charging hardware for electric vehicles. The company is in a growing industry, but electric-vehicle adoption is still in its early phases, and it’s unclear what the industry will look like in a few years. How many more people can we expect to transition to electric vehicles? How many businesses will implement EV charging on their premises?

This uncertainty creates a wider dispersion of potential outcomes. If the EV charging industry progresses in alignment with ChargePoint’s vision for the future, it could see substantial returns. If the industry heads down a different path, ChargePoint’s returns could be substantially lower. In addition, ChargePoint is an unprofitable company with relatively constrained financial resources.

The dispersion of potential outcomes is great enough that we assign ChargePoint an Uncertainty Rating of Extreme.

To summarize the discounts and premiums at which we recommend you consider buying or selling a stock:

Morningstar’s Uncertainty Rating vs. Stock Volatility

We believe that this Uncertainty Rating offers a better way to size up stocks than stock volatility or modern portfolio theory metrics that many others use as a proxy for risk.

There are a couple main reasons that we think it’s important to consider a range of possible future fair values, as opposed to a single most likely fair value:

1. Events rarely play out linearly. Major structural changes in an industry or a company are inherently hard to predict, and this approach helps open our analysts up to the idea that there may be several potential outcomes in store.
2. It improves the decision-making process. Only considering one possible outcome, and one possible path to that outcome, feeds into confirmation bias: that is, the tendency to ignore new information that doesn’t support our existing way of thinking. We believe that considering a range of possible outcomes facilitates the ability to assess new information in a less-biased way.

The upshot: Thinking about what could happen is just as useful—if not more so—as thinking simply about what is most likely to happen.

The Uncertainty Rating in Practice

All companies face some uncertainty, but the extent to which they face uncertainty is varied. Below, we offer a few examples of the levels of uncertainty.

• Low Uncertainty Rating. Several years from now, chances are Coca-Cola KO will still be selling carbonated drinks, Johnson & Johnson JNJ will still have products and devices throughout the healthcare products industry, and The Home Depot HD will still be a big-box retailer for category goods. Future sales growth rates are likely to be in a relatively tight band for this group, financial leverage at these firms is nominal or nonexistent, and we don’t think any single negative event is likely to sink these battleships.
• Medium Uncertainty Rating. Several of the biggest technology companies fall into the Medium Uncertainty Rating category, including Alphabet GOOGL, Microsoft MSFT, and Oracle ORCL. These companies have a big lead on their competition, are highly profitable, and have tons of cash. But because the technology space evolves so quickly, it’s hard to tell what these companies are going to look like in 10 years, much less what their growth rates and profitability are going to be.
• High Uncertainty Rating. The stocks holding High Uncertainty Ratings fall into a range of sectors—from ExxonMobil XOM to Netflix NFLX. ExxonMobil faces the risk of declining oil demand, while Netflix must contend with uncertainty in the future of streaming media.
• Very High Uncertainty Rating. For this category, consider a stock like Tesla TSLA, which faces uncertainty from a broad range of sources: the advent of autonomous vehicles, the entrance of lower-priced EVs into the market, and ESG risks around issues of product defects, patent litigation, and regulations requiring automakers and dealers to be separate.
• Extreme Uncertainty Rating. We reserve the Extreme Uncertainty Rating for only a few companies, but one example is Hawaiian Electric Industries HE, which is facing multiple lawsuits alleging the company’s responsibility for the Hawaiian wildfires. If the company is required to pay damages or a settlement, it would be a significant blow to its financials.

How to Use the Uncertainty Rating

The future is inherently uncertain, and that uncertainty is greater for some companies than others. But investors can use this rating to assess the extent of that uncertainty and evaluate the likelihood of seeing returns that justify that risk.

The Uncertainty Rating also interacts with the fair value estimate to fuel the Morningstar Rating for stocks, which sums up whether a stock is cheap, expensive, or fairly priced.

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