What is the Morningstar Rating for stocks?
This is the quantitative rating of the fair value of a company per share. The Morningstar analysts calculate this estimated fair value by forecasting how much free cash flow the company will generate in the future. This means the amount of cash a company still has after all its costs and investments have been paid and what is available for distribution of dividends to the shareholders of that company. This value is then adapted by taking into account time and risk. Cash generated next year is worth more than cash generated over a number of years. In the same way, cash of a stable and consistently profitable company is worth more than of a company in a strong cyclical sector.
Shares that are traded at a price that is significantly lower than the fair value estimated by Morningstar, receive more stars. For high-quality companies we require a smaller undervaluation than for medium-sized companies. That is for one simple reason: Morningstar trusts more in its cash flow forecasts for strong companies and therefore also in its value estimates of such companies. If the market price of a share is considerably higher than the fair value estimated by Morningstar, that share gets relatively few stars, regardless of how great Morningstar believes the company in question to be. Even the best company is bad business if an investor pays too much for the shares.
In short: 1 star for a share stands for maximum overvalued and 5 stars stands for maximum undervalued. 3 stars means a share is reasonably or fairly valued. The rate is on or near the level of the fair value given by the Morningstar share analysts to the share.