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Stock analysts use many different words to describe their ratings…[and] this article explains what the different ratings mean and how you can use them to make better investing decisions.
What Do Stock Analysts Do?
Stock analysts:
- are…[employed by] a financial firm or investment bank…
- analyze companies and decide whether their stocks are worth investing in,
- analyze financial statements, listen to quarterly conference calls, and may also get in direct contact with a company’s management and key customers,
- often do surveys and various types of research that gives them information on how well a company is doing,
- give a rating (buy, sell, hold, etc.) and a 12-month price target after they have completed their research…and
- then typically release extensive research reports on the stocks, along with predictions for earnings per share (EPS) and revenue for the coming quarters and years.
Despite analysts often being wrong, many institutional investors and regular investors use their ratings and reports when making investment decisions and, because of this, the ratings and price targets from stock analysts often lead to big price movements in individual stocks.
What Do the Most Common Analyst Ratings Mean?
Many analysts like to keep things simple and only give buy, hold, or sell ratings…[but] some analysts use different terms to describe their ratings, which makes it confusing to interpret what they mean…
The different analyst rating terms can fit into five general categories:
- Buy: Sometimes called “strong buy,” a buy rating is bullish and implies that the stock is likely to perform very well.
- Outperform: Also termed “overweight” or “moderate-buy.” Outperform is a mild buy rating and implies that the stock is likely to have higher returns than the overall stock market.
- Hold: A hold rating is a neutral rating, often called “market perform” or “equal weight.” This rating says there is no reason to buy the stock, but no particular reason to sell it either.
- Underperform: Also termed “underweight” or “moderate sell,” an underperform rating means that the stock is likely to perform slightly worse than the market as a whole.
- Sell: Sometimes called “strong sell,” a sell rating is pretty rare and usually only given if the analyst is extremely bearish on the stock. This rating implies that the stock should be sold or even shorted.
…When an analyst changes a previous recommendation, that is called an upgrade or downgrade. For example, changing from hold to outperform is an upgrade, while a change from buy to hold is a downgrade. When a stock gets upgraded or downgraded by an analyst, it often leads to a significant price movement.
How Are Analyst Rating Averages Calculated?
Websites that aggregate stock analyst ratings often give stocks a score of 1-5. The weighting of the ratings is 1 for buy, 2 for outperform, 3 for hold, 4 for underperform and 5 for sell. If the average rating is close to 5, that means that most analysts rate the stock as a sell but, if the average rating is close to 1, then most analysts have a “buy” or “strong-buy” rating…
Should You Invest Based On Analyst Ratings?
Analysts are frequently wrong, so you should be cautious when interpreting their ratings and recommendations…[and] stock analysts may also have a conflict of interest. In some cases, the firms they work for have positions in the stocks, which could have effects on the ratings. You should absolutely not buy or sell stocks based only on what stock analysts say. It is crucial to do your own research and come to your own conclusions.
Conclusion
Analyst projections for revenue and EPS are often quite accurate but their buy/sell/hold recommendations and price targets are not reliable at all. This doesn’t mean that analysts are bad at their jobs. Instead, it reflects how incredibly hard it is to predict what stock prices do in the short-term.