10 High-Risk Stocks to Avoid

Investors face many different types of financial risk. There’s the most basic risk—the risk of losing money. And then there’s the risk of missing your goals or, for retirees, the risk of outliving your assets. Those who invest conservatively run the risk of not keeping up with inflation, while bond investors face interest-rate and, if investing in lower-quality bonds, default risk. Investing internationally can involve currency and country risk. And particular sectors face their own sets of investment risks, too.

Today, we’re looking at individual stocks with risky valuation ratings. Specifically, we screened for stocks that earn a Morningstar Rating for stocks of just 1 star, which means they’re trading well above Morningstar’s fair value estimate of their worth. Given their inflated prices relative to what we think they’re worth, these stocks carry significant investment risk

10 High-Risk Stocks to Avoid Today

These overvalued stocks all earn 1-star Morningstar Ratings and carry the highest price/fair value ratios among the stocks Morningstar covers as of Sept. 10, 2024.

1. Wingstop WING
2. Arm Holdings ARM
3. The Trade Desk TTD
4. Palantir Technologies PLTR
5. Intuitive Surgical ISRG
6. NRG Energy NRG
7. Costco COST
8. Progressive PGR
9. W.W. Grainger GWW
10. Vistra VST

Most of the names on this list of stocks with high investment risk come from good companies. To wit: Seven of the companies on the list maintain solid competitive advantages (or what we’d call economic moats). Four of the companies are run by top managers who have a history of adeptly allocating capital and who thereby receive the highest Morningstar Capital Allocation Rating. And perhaps most notable, one of the companies on our list of high-risk stocks is among Morningstar’s Best Companies to Own, a list that features businesses scoring well on several quality-related Morningstar metrics.

What’s the investment lesson? A great company isn’t always a great stock to buy today; in fact, it can be a downright lousy stock to buy if it’s overvalued and doesn’t provide the buyer with a sufficient margin of safety.

Here’s a little bit about each overvalued stock on our high-risk stocks list along with some commentary from the Morningstar analyst who covers the company. All data is as of Sept. 10.

Wingstop

• Price/Fair Value: 2.26
• Fair Value Uncertainty: High
• Morningstar Economic Moat Rating: Narrow
• Morningstar Capital Allocation Rating: Exemplary
• Industry: Restaurants

Wingstop tops our list of high-risk stocks to avoid. While we think the chicken chain has carved out a narrow economic moat, it is run by a management team that has done an exceptional job of allocating capital and boasts a long runway for growth. “Market expectations appear unmoored from reality,” argues Morningstar senior analyst Sean Dunlop. The most overvalued stock on our list, Wingstop trades 126% above our $168 fair value estimate.

While we don’t quite foresee Wingstop achieving management’s target of becoming a top-10 restaurant brand within a decade, we do see an enviable development runway for the chicken chain, with our estimates calling for high-teens systemwide sales growth over that period. Our forecasts are underpinned by best-in-class unit economics and a sizable development pipeline, validating management’s target for more than 10% annual store growth over the long term. We believe that management’s strategy is cogent, with priorities falling into three key buckets: improving unit economics, driving brand awareness, and expanding into international markets.

Considering these points in sequence, we believe that an emphasis on the digital channel, comprising 68% of sales today, represents a durable growth lever, while a 45-million-member database can be leveraged to drive an uptick in visit frequency. Taken in tandem with menu innovations like the firm's chicken sandwich and ongoing growth in off-premises channels, we agree with management that $3 million average unit volumes are achievable. Better sales leverage should drive modest improvement to restaurant margins, while a mix shift toward boneless meat should reduce input cost volatility and commensurately increase franchise development interest.

On the brand awareness side, Wingstop has raised its national marketing budget to 5.3% of systemwide sales from 4%, eliminating less efficient local co-ops and competing more aggressively for national media spots. Between a larger contribution rate and increasing scale, with $3.5 billion in systemwide sales and nearly $160 million in advertising revenue in 2023, we believe that Wingstop should be able to close the recognition gap with its larger peers.

Last, international expansion looks like a natural evolution of the business, with the firm boasting a robust development pipeline and encouraging early unit economics in key markets like Mexico, the UK, Canada, and South Korea. In our view, international success provides the icing on the cake to an independently excellent growth story, with Wingstop targeting a self-assessed international addressable market of 4,000 units.

Read Morningstar’s full report on Wingstop.

Arm Holdings

• Price/Fair Value: 1.93
• Fair Value Uncertainty: High
• Morningstar Economic Moat Rating: Wide
• Morningstar Capital Allocation Rating: Standard
• Industry: Semiconductors

Arm Holdings is the first of three technology stocks on our list of high-risk stocks to avoid today. We assign the tech company a wide economic moat rating, as its ARM architecture is used in 99% of the world’s smartphone CPU cores, and it also has a high market share in other battery-powered devices like wearables, tablets, or sensors, explains Morningstar analyst Javier Correonero. Despite the company’s dominance, we think Arm stock is way overvalued, trading 93% above our $66 fair value estimate.

Arm Holdings does not sell chips, it develops CPU architecture and IP that it licenses to its clients. We believe Arm will remain the dominant architecture in smartphone CPUs, where it has a 99% market share, while maintaining a high market share in other mobile chips and battery-powered devices. Arm is also making inroads into the data center, where we expect it will gain market share versus x86, the dominant architecture.

Technology companies use Arm’s architecture to design their CPUs and other chips. Once the chip is designed the client can 1) sell its own device, like Apple’s iPhone or Samsung Galaxy or 2) sell chips to other device makers, like Qualcomm, which provides CPUs to smartphone makers. On top of licensing fees, Arm gets a royalty percentage of the value of the chips shipped. If a $1,000 smartphone has $50 of Arm content and Arm charges a 4% royalty rate to that customer, Arm gets 4% of the Arm content, or $2.

Arm is exposed to long-term growth trends in battery-powered devices, data centers, and automobiles. We estimate Arm’s royalty rates for its newest architecture, v9, are around 4% to 5%, double those of its predecessor v8, according to management. As v9 represents a larger portion of revenue, Arm’s blended royalty rate will go up. In the long term, we believe Arm can keep gradually increasing royalty rates as long as it reinvests accordingly in R&D to offer better chip performance and energy efficiency.

Arm offers two main types of licenses: off-the-shelf and architectural. In off-the-shelf agreements, Arm licenses a ready-to-use portfolio of CPU designs that the client can incorporate into its devices. The portfolio spans from very simple CPUs to more advanced ones, used in high-end smartphones or data center workloads. Architectural licenses are intended for large clients like Apple, Qualcomm, or Nvidia, where the client can add or delete architecture instructions to tailor the chips to its needs. Architectural licensees normally pay lower royalty rates than off-the-shelf ones to compensate for the higher R&D expenditures of developing custom chips. All licensees pay royalty fees per chip shipped on top of license fees.

Read Morningstar’s full report on Arm Holdings.

The Trade Desk

• Price/Fair Value: 1.92
• Fair Value Uncertainty: Very High
• Morningstar Economic Moat Rating: None
• Morningstar Capital Allocation Rating: Standard
• Industry: Software—Application

The Trade Desk provides a self-service platform that helps advertisers and ad agencies programmatically find and purchase digital ad inventory. Morningstar director Mike Hodel notes that the company hasn’t yet carved out an economic moat. “We do not believe The Trade Desk’s capabilities are differentiated enough from its competitors,” he adds. The Trade Desk stock is 92% overvalued compared with our $52 fair value estimate.

The Trade Desk has become one of the leading technology platform providers for advertisers and their ad agencies to purchase ad inventory made available by various publishers or content providers. We expect this demand-side platform provider, which helps ad buyers manage programmatic ad campaigns, will benefit from the ongoing growth of digital advertising spending.

The Trade Desk’s independence—it does not own media that could create bias in ad purchases and placement—likely has increased the trust of brands and their ad agencies in the firm’s platform. This position contrasts with Google’s platforms, which remain dominant but have lost share in serving ads to non-Google publishers, and Amazon’s rapidly growing ad business. The Trade Desk also provides methods to enhance data sharing and interoperability. Its platform is integrated with publishers or their supply-side platform providers, which allows the firm to better utilize its clients’ and the publishers’ data to optimize addressable ad campaigns in real time and measure campaign results. Over the past five years, The Trade Desk has increased its client count by about 50% to reach more than 1,100 ad agencies and other ad buyers. Revenue per client has also increased nearly threefold over this period as the firm has expanded its capabilities and the number of data sources clients can access.

The connection between and translation of data from many different sources has become the top priority for all participants in the digital advertising market as connections have weakened, thanks to changes in Apple’s privacy policies and Google’s plan to eliminate third-party cookies. The Trade Desk is investing in creating an encrypted user identifier, referred to as UID2. If widely adopted, the integration and utilization of data from multiple sources would become less costly and more efficient, increasing the effectiveness of digital ads. While The Trade Desk does not sell UID2 and only considers it an industrywide initiative, the identifier could attract more advertisers to its platform. However, the firm faces fierce competition from the likes of LiveRamp and Google on this front.

Read Morningstar’s full report on The Trade Desk.

Palantir Technologies

• Price/Fair Value: 1.83
• Fair Value Uncertainty: Very High
• Morningstar Economic Moat Rating: Narrow
• Morningstar Capital Allocation Rating: Standard
• Industry: Software—Infrastructure

After Palantir reported blockbuster second-quarter financial results, Morningstar upped its fair value estimate on the stock by $3 (nearly 19%) to better capture the artificial intelligence momentum lifting sales. “We continue to be optimistic about the firm’s AI opportunity as a deeply embedded player in the space with years of experience working with large commercial and government clients,” explains Morningstar analyst Malik Ahmed Khan. Although there’s a lot to like about the company, its shares are unattractive today. Palantir stock is 83% overvalued relative to our $19 fair value estimate.

We believe Palantir is well placed for long-term success as a leader in artificial intelligence/machine learning platforms. Its two main platforms, Gotham and Foundry, are well suited to help governments and commercial clients harness the power of data. Palantir’s platforms stand to materially benefit as organizations seek to expand their use of data to inform business decisions. We expect this secular tailwind to allow the company to land more clients while also expanding revenue from existing ones.

Big Data is ubiquitous and is harvested from almost every touch point across an organization. However, it’s not a guarantee that all AI/ML projects will lead to wonderful business outcomes, as organizations often fail to appreciate the complexities and intricacies within a multilayered data science project. AI/ML platforms like Gotham and Foundry enable organizations to develop solutions that leverage Big Data and result in business and operational efficiencies.

As a key player in this space, Palantir has a strategy of focusing on high-value, large organizations and developing bespoke AI/ML solutions that fit their business needs. While this strategy has led to the company landing large clients (both governments and commercial) that spend millions of dollars on its platforms, it has stunted customer growth as Palantir’s platforms are seen as too expensive for many large organizations. To counteract this, Palantir has shifted to a modular sales strategy with customers now able to purchase specific modules instead of onboarding an expensive platform at the onset. This is coupled with a usage-based pricing model that allows Palantir to land customers with low annual spending and ramp their expenditure on its platform up over time by either increasing usage or selling the customers additional modules.

We have a positive outlook on Palantir’s business and expect the firm to demonstrate financial success in both the governmental and commercial end markets. As the firm expands its top line via upselling and landing new clients, we also expect material margin expansion as the business grows and matures.

Read Morningstar’s full report on Palantir.

Intuitive Surgical

• Price/Fair Value: 1.83
• Fair Value Uncertainty: High
• Morningstar Economic Moat Rating: Wide
• Morningstar Capital Allocation Rating: Exemplary
• Industry: Medical Instruments and Supplies

A leader in robotic surgeries, Intuitive Surgical is one of three wide-moat stocks on our list of high-risk stocks to avoid. “Through its expanding installed base of more than 8,000 da Vinci systems and its vast procedure database, we think Intuitive Surgical has dug a wide moat around its business,” argues Morningstar director Alex Morozov. We think management has done an exemplary job of allocating capital, too. But Intuitive Surgical stock is simply too rich as it trades 83% above our $265 fair value estimate.

Intuitive Surgical continues to benefit from the ongoing global adoption of robotic surgery, even in the procedures we didn’t view as likely to convert. Our long-term positive view about the company’s competitive positioning is unchanged even as new competitors have finally arrived on the scene, and with the release of the next-generation platform early in 2024, Intuitive should maintain its dominance.

We don’t consider our long-term thesis for Intuitive to be particularly conservative. Even with the company’s procedures north of 2 million in 2023, we think the total addressable global market of several times the size still offers ample growth opportunities, particularly overseas. The ultimate ceiling for robotic surgery is virtually unlimited, with existing applications only scratching the surface of all possible procedures in soft tissue surgery that could migrate to the robot. A number of categories still offer sizable unpenetrated and underpenetrated opportunities, inside and outside the United States. Robotic surgery’s acceptance in most of the developed world remains significantly lower than in the US, and in the absence of formidable competitors (up until recently), Intuitive should continue to be the primary beneficiary of the positive trends.

We anticipate growth will start decelerating in a few procedures, particularly in the US, with penetration rates hitting a ceiling. However, there are ample opportunities for growth outside mature procedures. Intuitive is proactively taking the right steps to improve its economic appeal, which has allowed it to make material inroads into the markets and the procedures we have viewed historically as less suitable for a robot. While most demand has historically been US-based, Intuitive is increasingly relying on growth internationally, where it has seen more skepticism in the past. International system placements have recently surpassed US installations, which supports our long-term forecast of accelerating adoption.

Read Morningstar’s full report on Intuitive Surgical.

NRG Energy

• Price/Fair Value: 1.81
• Fair Value Uncertainty: High
• Morningstar Economic Moat Rating: None
• Morningstar Capital Allocation Rating: Standard
• Industry: Utilities—Independent Power Producers

One of the largest retail energy providers in the US, NRG Energy’s transformation in 2017-20 cut the business in half, improved its credit metrics, and generated substantial cash to use for dividends, stock buybacks, and acquisitions, says Morningstar strategist Travis Miller. But NRG stock looks expensive as it trades 81% above what we think it is worth, $43 per share. “We think the market is too optimistic about long-term profit margins,” concludes Miller.

NRG Energy has reconfigured its business, management team, and board of directors in the past few years. Once one of the largest power generators based mostly in Texas, NRG now is a nationwide retail energy and home services company.

We estimate NRG's legacy power generation business will represent only about 20% of consolidated earnings on a run-rate basis after its $5.2 billion Vivint Smart Home acquisition in March 2023 and $1.75 billion sale of its 44% interest in the South Texas Project nuclear plant in November 2023.

The strategic reshuffling started in 2021 when NRG’s $3.625 billion Direct Energy acquisition closed. NRG then sold most of its Northeast power generation fleet and closed four Midwest power plants, cutting costs and strengthening its balance sheet ahead of the Vivint deal.

NRG's consumer-facing retail energy and home services businesses give it a different risk profile than other utilities. A higher share of retail energy earnings helps offset the long-term threat to NRG's legacy fossil fuel generation fleet. However, the new direction leaves NRG more exposed to customer energy usage trends and volatility.

NRG will benefit the most if electricity demand grows in its key markets, particularly Texas, which still represents half its earnings even with Vivint. Recent summer heat spells and Winter Storm Uri in February 2021 show that growing electricity demand can create more energy price volatility and risk. Uri resulted in $1 billion of gross losses for NRG in just two weeks.

Apart from acquisitions, NRG has limited growth investment plans. We expect it to return most of its free cash flow to shareholders through dividends and share buybacks.

NRG began shrinking its generation exposure in 2016. NRG divested half of its generation fleet, brought in nearly $3 billion of cash, and eliminated $10 billion of debt. In the spring of 2017, NRG sent its subsidiary GenOn Energy into bankruptcy, and in 2018, it sold its renewable energy business, its 47% stake in NRG Yield, and its South Central generation.

Read Morningstar’s full report on NRG Energy.

Costco

• Price/Fair Value: 1.75
• Fair Value Uncertainty: Medium
• Morningstar Economic Moat Rating: Wide
• Morningstar Capital Allocation Rating: Exemplary
• Industry: Discount Stores

Costco is the only name featured on our high-risk stocks list that’s also included on our Best Companies to Own list. “Best companies” are those with significant competitive advantages, that are run by managers who’ve done a good or exemplary job of allocating capital, and that have reliable cash flows. We’re confident in the firm’s financial outlook and think the company’s wide moat is secure, says Morningstar analyst Noah Rohr. But unfortunately, Costco stock is just too rich, with shares trading 75% above our $510 fair value estimate.

Despite operating amid a cutthroat retail industry where competitive advantages are difficult to manifest and omnichannel penetration continues to burgeon from the likes of wide-moat Amazon and Walmart, we believe Costco boasts a unique edge because of its loyal membership base, meticulous cost management, and impressive scale.

Costco emphasizes a frugal cost structure, evidenced by its no-frills shopping environment and limited product assortment. The retailer avoids maintaining costly product displays, limits internal distribution costs by storing inventory at the point of sale in its warehouses, and offers a concentrated product assortment of about 4,000 stock-keeping units per warehouse, resulting in more streamlined product procurement. With impressive cost management and unmatched sales volume per warehouse, Costco’s fixed cost leverage is magnified as its selling, general, and administrative, or SG&A, margin of 9% to 10% is well below the roughly 20% held by most competing retailers such as Walmart and Target. Costco’s resonating value proposition of bargain prices on quality items in bulk quantities successfully drives loyal consumers to its vast physical warehouses, resulting in steady membership growth and an impressive 90% renewal rate (93% in the US and Canada) from its 74 million global members, even amid rising membership fees (typically every five to six years).

While competitive angst shows little signs of abating, we believe Costco is poised to continue driving traffic to its stores. About two thirds of the firm’s core product sales (excluding fuel and ancillary businesses) comprise food and grocery items, which we view as less susceptible to omnichannel penetration owing to the poor unit economics of delivering low-margin bulk items to consumers’ homes. We also view the warehouse club model as difficult to replicate because of the vast scale needed to leverage fixed real estate costs. With a commanding industry position (Costco boasts over 60% market share in the domestic warehouse club industry, per Euromonitor) and unique business model, we think Costco’s value proposition is supportive of profitable top-line growth both domestically and abroad.

Read Morningstar’s full report on Costco.

Progressive

• Price/Fair Value: 1.73
• Fair Value Uncertainty: Medium
• Morningstar Economic Moat Rating: Narrow
• Morningstar Capital Allocation Rating: Exemplary
• Industry: Insurance—Property & Casualty

Progressive underwrites private and commercial auto insurance and specialty lines and has carved out a narrow economic moat, despite fierce competition. In fact, Morningstar senior analyst Brett Horn calls Progressive “one of the strongest franchises in the insurance industry.” Management earns high marks for its capital-allocation skills, which include sound balance-sheet management and allocating capital to its high-return businesses. Nevertheless, Progressive stock is overpriced, trading well above our $144 fair value estimate.

Progressive is one of the strongest franchises in the insurance industry and has consistently generated industry-leading returns, but the company has seen fairly dramatic volatility as the auto insurance industry has been on a roller-coaster ride over the past several years.

In the years before the pandemic, insurers saw an uptick in costs, as a multitude of factors ranging from low gas prices to distracted driving pushed up claims. This compressed industry underwriting margins, but Progressive and the industry executed a more than sufficient pricing response. As such, Progressive fully moved past the issue, and before the pandemic, underwriting margins were at the high end of the company's historical range.

At the beginning of the pandemic, quarantine efforts led to a dramatic decline in miles driven and claims. Progressive offered rebates to customers as a result, but it and its peers still enjoyed abnormally high underwriting profits in 2020.

Ultimately, though, drivers returned to the road and the pandemic restarted the pricing cycle at a less attractive point. Over the past year or two, insurers have been absorbing lower prices and a rise in claims costs owing to factors beyond the impact of more-normalized driving behavior. However, the industry has once again pushed through large pricing increases, and we expect mean reversion over time. We think some auto insurers will endure a relatively difficult period in the near term, but Progressive has been weathering this period much better than its peers. That result came at the cost of lower policies in force at points, but this has now reversed and Progressive’s relatively early pricing response is now paying some dividends, with the company seeing stronger growth and profitability than peers. With industry conditions improving and Progressive holding a relative edge, the near-term outlook looks strong, in our view, especially considering the benefit the company is now seeing from higher interest rates.

Read Morningstar’s full report on Progressive.

W.W. Grainger

• Price/Fair Value: 1.66
• Fair Value Uncertainty: Medium
• Morningstar Economic Moat Rating: Narrow
• Morningstar Capital Allocation Rating: Standard
• Industry: Industrial Distribution

Although it operates in a fragmented market, W.W. Grainger has managed to carve out a narrow economic moat, argues Morningstar director Brian Bernard. Most of this industrial distributor’s business focuses on large enterprises with complex procurement systems that appreciate the company’s ability to adeptly manage their accounts and provide inventory management services, which neither smaller industrial distributors nor online players can match. That being said, W.W. Grainger stock looks 66% overvalued today.

W.W. Grainger operates in the highly fragmented maintenance, repair, and operating product distribution market, where its over $13 billion of high-touch solutions sales in North America represents only 7% market share. Its endless assortment business has less than 1% market share in the US. The growing prevalence of e-commerce has intensified the competitive environment because of more price transparency and increased access to a wider array of vendors, including Amazon Business, which has entered the mix. As consumer preference began to shift to online and electronic purchasing platforms, Grainger invested heavily in improving its e-commerce capabilities and restructuring its distribution network. Still, the company had work to do on its pricing. Grainger historically relied on a pricing model that applied contractual discounts to high list prices. Leading up to 2017, though, this model made it difficult to win new business. To address this problem, Grainger rolled out a more competitive pricing model. Lower prices hurt gross profit margins, but volume gains, especially among higher-margin spot buys and midsize accounts, have offset price reductions and helped the company meet its 12%-13% operating margin goal by 2019 (12.1% adjusted operating margin that year). Over the past two years, Grainger has enjoyed strong margin expansion, supported by freight and supply chain efficiencies, with operating margin reaching 15.6% in 2023.

Grainger continues to expand its endless assortment strategy, but we’re skeptical of the margin expansion opportunity for this business, given strong competition in the space from the likes of Amazon Business and others. Still, we believe Grainger has distinct competitive advantages in its traditional business, such as its long-standing relationships with large customers and its inventory management solutions, which should help it earn excess returns over the next 10 years.

Read Morningstar’s full report on W.W. Grainger.

Vistra

• Price/Fair Value: 1.65
• Fair Value Uncertainty: High
• Morningstar Economic Moat Rating: None
• Morningstar Capital Allocation Rating: Standard
• Industry: Utilities—Independent Power Producers

Vistra wraps up our list of high-risk stocks to avoid. Although the utilities’ profit margins have been heading higher, Morningstar’s Miller thinks the market is overly enthusiastic about Vistra’s long-term profit margins. We admit, though, that the businesses produce ample cash flow to keep the firm in a solid financial position with plenty of liquidity. Vistra stock looks significantly overvalued, trading 65% above our $46 fair value estimate.

Vistra Energy is entering its second phase of life since splitting off as a stand-alone entity in 2016, following the Energy Future Holdings bankruptcy. It is well-positioned to benefit from the increasing electrification of the economy and potential electricity demand growth from data centers.

The $5.7 billion acquisition of Energy Harbor that closed in March 2024 and the split into two businesses—Vistra Vision and Vistra Tradition—expands Vistra's energy market exposure outside of Texas and boosts its clean energy credentials.

We estimate that Vistra Vision, which includes four nuclear plants, Vistra’s clean energy projects, and the retail business, will start out larger than Vistra Tradition and grow faster with its renewable energy investment plans. The split structure lends itself well to an eventual sale or spinoff of either business.

Investors remain highly exposed to volatile electricity and natural gas markets, creating more risk than most utilities. Vistra's contracted clean energy business offsets some of this market risk.

We think the Energy Harbor acquisition and a corporate structure that can attract clean energy direct investment will result in more stable cash flows, a durable dividend, and regular share buybacks. We expect Vistra to continue closing coal plants until its generation fleet is mostly highly efficient natural gas plants.

Vistra’s expansion of its nuclear and renewable energy fleet has a different flavor from its $2.27 billion acquisition of Dynegy in 2018, which tripled the size of its fossil-fuel generation fleet. The rock-bottom price and cost synergies made the Dynegy deal highly value-accretive. Vistra’s only significant stumble since exiting the Energy Future Holdings bankruptcy was Texas’ Winter Storm Uri in February 2021, which caused more than $2 billion of gross losses.

Vistra’s ample free cash flow and diversified business mix following the Dynegy and Energy Harbor acquisitions make it unlikely it would experience a bankruptcy like Energy Future Holdings, which came just seven years after several high-profile investors closed a $45 billion leveraged buyout, the largest ever at the time.

Read Morningstar’s full report on Vistra.

How Does the Morningstar Rating for Stocks Work?

The Morningstar Rating for stocks indicates whether a stock is undervalued or overvalued based on a stock’s current market price relative to our fair value estimate, adjusted for what we call uncertainty.

We calculate our fair value estimate for a stock based on how much cash we think a company will generate in the future. Of course, some companies have stable, predictable cash flows; others, meanwhile, have cash flows that are less reliable. Because of that, Morningstar’s analysts are more confident in the fair value estimates of some companies than of others. To account for their level of certainty behind a given fair value estimate, we assign Morningstar Uncertainty Ratings to stocks.

Think of the Uncertainty Rating as a way to ensure that you’re getting a suitable margin of safety for investing in a stock. You’d expect a smaller margin of safety for a stock with very low uncertainty around its fair value, while you’d want a larger margin of safety before buying a stock with less certain cash flow expectations.

We therefore adjust our fair value estimates to account for uncertainty and represent the result in our Morningstar Rating for stocks. Stocks that earn 1 or 2 stars are considered overvalued; stocks that earn 3 stars are fairly valued; and stocks that earn 4 or 5 stars are undervalued.