?

Infosys Ltd 500209

Last Price 2278.00 INR Fair Value Consider Buy 3050.00 INR 2135.00 INR

[XBOM]

QQQQ
Economic Moat Narrow
TM

Consider Sell 4117.50 INR

Uncertainty Medium

Stewardship .

Morningstar Credit Rating Industry Information Technology Services .

Infosys Struggles Far From Over, but We Continue to Believe in Firms Long-Term Potential
by Swami Shanmugasundaram, CFA Equity Analyst Analysts covering this company do not own its stock. Pricing data through April 12, 2013. Rating updated as of April 12, 2013. Currency amounts expressed with "$" are in U.S. dollars (USD) unless otherwise denoted.

its operations when demand picks up, without compromising cost and quality. The company extended this commitment to pursue high-quality standards to other aspects of its business, including physical and Analyst Note Apr. 12, 2013 | Swami Shanmugasundaram, CFA technological infrastructure, human resource management, financial accounting, and Infosys started its fiscal 2013 last April on a dismal note corporate-governance practices. These actions helped and ended it in the same fashion. For the second Infosys differentiate itself from its peers. consecutive year, Infosys offered subpar revenue guidance (6%-10% growth) that trails the industry forecast As with other offshore IT service providers, Infosys (12%-14% growth) by a wide margin. Additionally, no foundation was built around its legacy application earnings guidance from the firm for the first time in its development and maintenance business. Though the history has raised questions about its execution strategy business still accounts for a significant portion of the (pricing in particular) in the near future. It very much looks companys revenue, its overall contribution has declined like Infosys is more than willing to compromise on its (38% of total revenue in fiscal 2012 versus 48% in 2007) operating margins to drive top-line growth. While we are as Infosys expanded its offerings and moved up the IT slightly concerned about its extended struggles, we services value chain. The companys comprehensive continue to believe in the companys long-term potential, portfolio includes products and services that span the IT given its entrenched client base and wide portfolio of services spectrum, starting from high-end consulting and offerings. Accordingly, we plan to maintain our fair value moving on to package implementation and even low-end estimate and narrow moat rating. business process outsourcing. These new service offerings provide Infosys with new growth avenues and enable it to We don expand its penetration with existing clients. The companys ability to offer end-to-end service offerings, coupled with its fully developed global delivery model, Thesis Jan. 23, 2013 | Swami Shanmugasundaram puts it in an elite league of service providers (Accenture, Infosys Technologies, one of the most recognizable names IBM, and Capgemini) that can offer a complete set of in offshore information technology services, is best known integrated services. for its operational excellence, innovation, and corporate-governance standards. The companys strength lies in its comprehensive services portfolio, mature and well-managed global delivery model, and long-standing client relationships. Infosys was a pioneer in developing the global delivery model, which provided it with a formidable competitive advantage when offshore outsourcing gained momentum in the early 1990s and later became an integral part of the IT services industry. The company proactively invested, and continues to invest, a significant portion of its resources in developing and improving high-quality processes and methodologies. This not only helps Infosys streamline its operations and deliver quality services to clients, but also makes it easier for the company to scale Infosys boasts a large and expansive base of more than 775 active customers. The company has developed strong working relationships with top management at these companies, and most of its clients have been with Infosys for a long time. A large portion of new business is generated through existing relationships in the IT services industry, and Infosys larger client base gives it a slight edge. Further, an established client base provides good visibility on revenue streams--repeat business accounts for more than 98% of Infosys revenue. Despite all the positives, Infosys recent lackluster performance indicates that all is not well with the company. The firm is facing issues on many fronts and the

Infosys Ltd 500209

Last Price 2278.00 INR Fair Value Consider Buy 3050.00 INR 2135.00 INR

[XBOM]

QQQQ
Economic Moat Narrow
TM

Consider Sell 4117.50 INR

Uncertainty Medium

Stewardship .

Morningstar Credit Rating Industry Information Technology Services .

chief among them is its stance on premium pricing. Given the increased commoditization of traditional outsourcing services, we think it will be difficult for Infosys to substantiate its case for premium pricing in its legacy application development and maintenance offerings. Slowdown in IT spending by financial service companies, which make up one third of its business, is also a cause of concern for Infosys. These issues will likely keep Infosys growth in check in the near term, in our opinion. Despite recent hiccups, we remain optimistic about Infosys long-term prospects, as its fundamentals remain strong.

Risk

Infosys and other offshore IT services firms are exposed to cyclical downturns in technology spending. An economic slowdown may force clients to delay or reduce their IT spending, which would lower the demand for Infosys services. The companys revenue and margins would be hurt if the Indian rupee were to appreciate strongly against the U.S. dollar.

Bulls Say

Valuation, Growth and Profitability

Our fair value estimate for Infosys is INR 3,050 per share. We expect the company to continue to face modest headwinds in the near-term as it attempts to strike a fine balance between revenue growth and operating margins. In the past, Infosys was known for its rigid stand on pricing, which severely hurt its top line growth. In an effort to arrest the slide and drive growth, Infosys has been more flexible in its negotiation with clients on contract structures. The change in stance should help drive growth at Infosys in the future. Overall, we forecast Infosys revenue to grow at a CAGR of 9% over the next five years.

Infosys capitalized on the strong demand for offshore IT services and has established long-standing relationships with its clients, leading to substantial recurring revenue opportunities. The companys solid profitability, coupled with limited reinvestment needs, drives strong free cash flow. Increased traction for offshore outsourcing should act as a tailwind for Infosys over the medium term.

Bears Say

On the profitability front, we expect to see a gradual contraction in Infosys operating margins as the company succumbs to pricing pressure from customers and competitors. We also expect the firm to face headwinds from wage inflation. However, the companys flexible operating model should help partially offset the negative impact from wage inflation and lower pricing. We forecast operating margins to compress by about 250 basis points during our five-year forecast period. We think the new normal for Infosys will be operating margins in mid-20s range, down from its historical high-20s level.

Infosys insistence on premium pricing could hurt its future growth opportunities. Infosys participates in the highly fragmented IT services industry, which is extremely competitive and subject to pricing pressure. Foreign currency fluctuations can adversely affect Infosys operating results, as the company earns its revenue in multiple currencies while its cost base is primarily in Indian rupees.

Financial Overview

Financial Health: Infosys is in excellent financial health. The company maintains a pristine balance sheet with no debt. Its cash and cash equivalents totaled $4.1 billion at the end of fiscal 2012. Infosys generates strong free cash flows, which averaged 20% of revenue in the past five

2013 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.

Infosys Ltd 500209

Last Price 2278.00 INR Fair Value Consider Buy 3050.00 INR 2135.00 INR

[XBOM]

QQQQ
Economic Moat Narrow
TM

Consider Sell 4117.50 INR

Uncertainty Medium

Stewardship .

Morningstar Credit Rating Industry Information Technology Services .

years.

Company Overview

Profile: Founded in 1981 and based out of Bangalore, India, Infosys Technologies is a leading global provider of IT-related products and services. Its service portfolio includes consulting, system integration, package implementation services, software development, and business process outsourcing. Infosys serves clients primarily in the North American and European markets with a focus on the financial services, manufacturing, telecom, retail, and utilities/transportation/logistics industries. Management: We believe stewardship at Infosys is good. Infosys is led by CEO S.D. Shibulal and chairman K.V. Kamath. Shibulal co-founded the firm in 1981 with executive co-chairman S. Gopalakrishnan, and both have been instrumental in the growth of the company. Most of the executives working under Shibulal are longtime Infosys employees and are talented leaders with extensive industry experience. From an operational and strategic point of view, we believe the management team is one of the best in the industry. Infosys has done a good job of returning excess capital to shareholders. During the last five years, the company had returned more than $2.4 billion to shareholders through dividends.

2013 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.

Infosys Ltd 500209

Last Price 2278.00 INR Fair Value Consider Buy 3050.00 INR 2135.00 INR

[XBOM]

QQQQ
Economic Moat Narrow
TM

Consider Sell 4117.50 INR

Uncertainty Medium

Stewardship .

Morningstar Credit Rating Industry Information Technology Services .

Analyst Notes
Apr. 12, 2013 Infosys Struggles Far From Over, but We Continue to Believe in Firms Long-Term Potential

Infosys started its fiscal 2013 last April on a dismal note and ended it in the same fashion. For the second consecutive year, Infosys offered subpar revenue guidance (6%-10% growth) that trails the industry forecast (12%-14% growth) by a wide margin. Additionally, no earnings guidance from the firm for the first time in its history has raised questions about its execution strategy (pricing in particular) in the near future. It very much looks like Infosys is more than willing to compromise on its
Jan. 11, 2013

operating margins to drive top-line growth. While we are slightly concerned about its extended struggles, we continue to believe in the companys long-term potential, given its entrenched client base and wide portfolio of offerings. Accordingly, we plan to maintain our fair value estimate and narrow moat rating. We don

3Q Shows Early Indication That Infosys 3.0 Strategy Is Finally Beginning to Work

Infosys reported strong third-quarter results on improved business mix, which we believe could be an early indication that its Infosys 3.0 strategy is finally beginning to work. The company now must demonstrate that its strong third-quarter result is not a one-off and it can sustain this momentum. Third-quarter revenue grew 6.3% sequentially to $1.9 billion. Incremental revenue from the Lodestone acquisition added 2 percentage points to the growth. The strong top-line growth is particularly impressive as it came in the December quarter, which is traditionally a weaker period because of holidays and furloughs. Infosys solid performance could be attributed to shift in business mix toward consulting and system integration services. Revenue from consulting and system integration services grew 15.6% sequentially as the company was able to ramp up fairly quickly on some of its recent new contracts, and it accounted for 32.6% of total revenue, up from 30% last quarter. Based on the companys recent new signings (including $731 million in new contract value during the quarter), we think its very likely that Infosys will be able to sustain its momentum in the near term. The quarter was not without its challenges. Infosys reported modest 1.9% growth in volume and management

maintained its cautious tone during the commentary. We expect volume growth to pick up as Infosys softens its stance on its pricing strategy. In the past, Infosys was known for its rigid stand on pricing, which severely hurt its growth prospects in the past few quarters. These days, Infosys has been more flexible in its negotiation with clients on contract structures. As the perception changes, we expect volume growth to return gradually. The operating margin came in at 26.1% excluding Lodestone, down 500 basis points from last year and 20 basis points sequentially. Margin compression was largely expected as the company had to absorb the impact from higher wages and lower pricing during the quarter. In an effort to match the actions of its competitors and to keep employee attrition low, Infosys rolled out salary hikes across the board during the quarter. In terms of pricing, management commented that pricing declined by a steep 3.5% on a year-over-year basis. We dont expect a significant decline in margin, although we wouldnt be surprised to see minor variations (20-50 basis points) in the near term. Infosys employee utilization rates remains low compared with its historical levels and its competitors. Over the past few quarters, Infosys has been operating at a 70% utilization level compared with its historical high 70s. Employee utilization rates remains one of the key operating

2013 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.

Infosys Ltd 500209

Last Price 2278.00 INR Fair Value Consider Buy 3050.00 INR 2135.00 INR

[XBOM]

QQQQ
Economic Moat Narrow
TM

Consider Sell 4117.50 INR

Uncertainty Medium

Stewardship .

Morningstar Credit Rating Industry Information Technology Services .

Analyst Notes (continued) levers, and Infosys could easily use it to maintain or possibly expand its margins. Additionally, as a part of Infosys 3.0, the company has been focusing on high-end consulting and system integration assignments, where pricing pressure is relatively minimal.

Overall, Infosys delivered a solid quarter, and the improving results reinforce our view that the company could claw its way back from its recent slump.

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.

2013 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 Apr. 12, 2013

Rating updated as of Apr. 12, 2013

Fiscal year-end: March

Infosys Ltd 500209

Founded in 1981 and based out of Bangalore, India, Infosys Technologies is a leading global provider of IT-related products and services. Its service portfolio includes consulting, system integration, package implementation services, software development, and business process outsourcing. Infosys serves clients primarily in the North American and European markets with a focus on the financial services, manufacturing, telecom, retail, and utilities/transportation/logistics industries.
Morningstar Rating

Sales INR Mil

Mkt Cap INR Mil

Industry

Sector

7,231
Last Price Fair Value

1,301,655
Uncertainty

Information Technology Technology Services

Economic Moat
TM

QQQQ

2278.00

3050.00 2439 1511

Medium 2615 1101

Narrow 3494 2169

Stewardship Grade

. per share prices in INR 3010 2268

Annual Price High Low Recent Splits

709.38 1084 1520 302.50 525.00 925.00

4:1

2401 1225
2:1

2017 1040

3454 2333

2990 2102

Price Volatility
Monthly High/Low Rel Strength to S&P 500
2002.0

52 week High/Low 3010.00 - 2101.65 10 Year High/Low 3493.95 - 302.50 Bear-Market Rank 0 (10=worst) Trading Volume Million

702.0

Electronics City Hosur Road Bangalore, Karnataka 560 100 Phone: 91 8028520261 Website: http://www.infosys.com

402.0

1.1

Growth Rates Compound Annual

Grade: B 1 Yr 3 Yr 5 Yr 10 Yr

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

YTD

Stock Performance Total Return % +/- Market +/- Industry Dividend Yield % Market Cap INR Mil
Financials

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

15.8 13.2 14.5 37.0 7.4 -15.4 -18.9 -31.8

Current

14.5 13.6 10.1 -3.8 20.1 -3.5 -5.4 -13.6

5 Yr Avg

17.8 18.8 14.9 7.4 18.4 11.7 -0.0 8.1

Ind

29.1 27.4 17.0 34.2 21.2 20.1 6.1 13.8

Mkt

17.2 52.6 44.1 51.1 -20.5 -34.7 135.2 34.3 -18.7 -14.4 -1.8 -9.2 43.6 41.1 37.5 -24.0 3.8 111.8 21.5 -18.7 -27.8 -13.5 -28.8 18.3 46.7 22.3 -13.9 8.0 22.1 5.7 6.8 -25.4 -9.5 0.5 0.4 0.4 1.1 0.7 3.3 0.9 0.7 1.3 1.6 1.6 184278 278426 810832 1234762 1010736 640127 1486820 1968115 1579865 1324797 1301655
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 TTM

754 44.6 219 29.0 195

1063 43.3 293 27.6 270

1592 43.2 456 28.6 419

2152 42.2 599 27.8 555

3090 42.5 852 27.6 850

4176 41.3 1151 27.6 1155

4663 42.1 1374 29.5 1281

4804 42.8 1460 30.4 1313

6041 42.1 1779 29.4 1499

6994 41.1 2013 28.8 1716

7231 38.9 1980 27.4 1744

Revenue INR Mil Gross Margin % Oper Income INR Mil Operating Margin % Net Income INR Mil Earnings Per Share INR Dividends INR Shares Mil Book Value Per Share INR Oper Cash Flow INR Mil Cap Spending INR Mil Free Cash Flow INR Mil
Profitability

Return on Equity % Return on Assets % Fixed Asset Turns Inventory Turns Revenue/Employee INR K Gross Margin % Operating Margin % Net Margin % Free Cash Flow/Rev % R&D/Rev % Financial Position
Grade:

27.5 23.6 7.0 . 46.5 38.9 27.4 24.1 18.5 .

30.0 26.1 5.4 . 45.0 * 41.9 29.1 26.4 21.3 .

. . . . . . . . . .

. . . . . . . . . .

0.73 1.01 0.76 1.00 1.50 2.02 2.25 2.30 2.62 3.00 3.05 0.06 0.08 0.10 0.15 0.53 0.31 0.85 0.50 0.55 0.75 0.67 266 267 547 558 566 570 571 571 571 571 571 111.97 155.20 101.11 148.53 212.99 273.43 334.78 422.54 476.01 591.11 650.83 211 -43 168
2003

373 -93 280

2004

344 -186 158

2005

599 -246 353

2006

862 -339 523

2007

1149 -374 775

2008

1409 -285 1124

2009

1457 -143 1314

2010

1298 -285 1013

2011

1681 -320 1361

2012

1728 -388 1340

TTM

03-12 INR Mil

12-12 INR 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

4047 . 1524 5945 1063 229 7537 312 . 937 . 961 6576
5 Yr Avg Ind

2740 . 1671 6085 1115 440 7955 240 . 1108 . 1142 6813
Mkt

33.2 36.5 25.9 1.28 1.1

2003

29.4 34.2 25.4 1.16 1.2

2004

32.4 38.0 26.3 1.23 1.2

2005

31.5 35.9 25.8 1.22 1.1

2006

33.1 37.3 27.5 1.20 1.1

2007

30.5 34.9 27.7 1.10 1.1

2008

28.9 33.3 27.5 1.05 1.2

2009

24.9 28.7 27.3 0.91 1.1

2010

22.8 26.1 24.8 0.92 1.1

2011

23.6 27.0 24.5 0.96 1.1

2012

23.6 27.5 24.1 0.98 1.2

12-12

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

445 . 626 .
2003

720 . 954 .
2004

885 . 1253 .
2005

1300 . 1837 .
2006

1743 . 2717 .
2007

2558 . 3910 .
2008

2583 . 3784 .
2009

3951 . 5361 .
2010

4496 . 6122 .
2011

5008 . 6576 .
2012

4977 . 6813 .
TTM

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

13.4 . 3.4 4.9 10.3

18.4 . 4.7 5.8 18.3

35.0 . 9.2 11.0 32.8

38.5 . 10.1 12.6 40.8

23.2 . 6.6 7.0 20.7

10.4 . 2.8 3.7 10.2

24.9 . 6.9 6.6 22.1

30.4 . 7.7 7.7 32.1

18.0 . 4.4 5.1 19.5

13.9 . 3.4 3.5 14.0

13.7 . 3.3 3.5 13.8

Price/Earnings P/E vs. Market Price/Sales Price/Book Price/Cash Flow

Quarterly Results
Revenue INR Mil Mar 12 Jun 12 Sep 12 Dec 12

Industry Peers by Market Cap

Mkt Cap INR Mil Rev INR Mil P/E ROE%

Price/Earnings Forward P/E Price/Cash Flow Price/Free Cash Flow Dividend Yield % Price/Book Price/Sales PEG Ratio

13.7 13.4 13.8 17.8 1.6 3.5 3.3 1.2

19.5 . 19.6 24.0 . 5.3 5.0 .

. . . . . . . .

. . . . . . . .

Most Recent Period Prior Year Period

Rev Growth %

1771.0 1752.0 1797.0 1911.0 1602.0 1671.0 1746.0 1806.0

Mar 12 Jun 12 Sep 12 Dec 12

Infosys Ltd

1301655

7231 13.7

27.5

Most Recent Period Prior Year Period

Earnings Per Share INR

10.6 23.6
Mar 12

4.8 23.1
Jun 12

2.9 16.7
Sep 12

5.8 13.9
Dec 12

Major Fund Holders

% of shares

Most Recent Period Prior Year Period

0.81 0.70

0.73 0.67

0.75 0.72

0.76 0.80

. . .
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

2013 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.

2013 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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