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Why Moats Matter: The Morningstar Approach to Stock Investing by Heather Brilliant, Elizabeth Collins

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Chapter 6The Importance of Valuation

Contributed by Joel Bloomer, Matt Coffina, and Gareth James, members of Morningstar’s Moat Committee and contributors to Morningstar’s valuation methodology

So far we’ve talked about how to identify high-quality companies, including those with economic moats protecting their excess returns, those with improving competitive advantages, and those that are good stewards of capital. Now we explore how to value these businesses, and how to know when they are cheap or expensive.

When we talk about value we are referring specifically to intrinsic or fair value as opposed to share price. We agree with Warren Buffett’s famous quote that “price is what you pay; value is what you get.” Over the long term, we expect share prices to converge toward fair value, but in the short and medium term, stock markets can overreact and underreact to events, thereby creating investment opportunities. In such situations, a robust understanding of the underlying fair value of a business is imperative to making sound investment decisions and differentiates the investor from the speculator.

The intrinsic value of a business can be described as the present value of the excess cash generated during its remaining life. This methodology is commonly known as discounted cash-flow, or DCF, analysis, and the discount rate should reflect an adequate return on investors’ capital. Of course, no one knows the exact intrinsic value of a business, but there are some tools we can employ ...

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