In order to reach an opinion and communicate the value and volatility of a covered security, analysts research public financial statements, listen in on conference calls, and talk to managers and the customers of a company, typically in an attempt to come up with findings for a research report.
Analysts research public financial statements, listen in on conference calls, and talk to managers and the customers of a company. Ultimately, through all this investigation into the company's performance, the analyst decides whether the stock is a "buy," "sell," or "hold."
Key Takeaways
- It is important to understand each rating group's rating styles, as there is no universal ranking system.
- "Buy, hold, and sell" recommendation meanings are not as transparent as they first seem; a plethora of terms and variance in meanings exist behind the curtain.
- Ratings are meant to complement or be used as a tool for existing strategies, not as a base to build them on.
- Ratings are independent of companies, and there are legal ramifications for analysts who rate a stock they have an interest in.
The Scale of Ratings
However, the analyst rating scale is a tad trickier than the traditional classifications of "buy, hold, and sell." The various nuances, detailed in the following chart, include multiple terms for each of the ratings ("sell" is also known as "strong sell," "buy" can be labeled as "strong buy"), as well as a couple of new terms: underperform and outperform.
:max_bytes(150000):strip_icc()/BuySellandHoldRatingsofStockAnalysts3-6fc3f5431b974f20bb9585fc61fec4a7.png "Understanding Buy, Sell, and Hold Ratings of Stock Analysts (1)")
To top it off, not every firm adheres to the same ratings scheme: an "outperform" for one firm may be a "buy" for another and a "sell" for one may be a "market perform" for another. Thus, when using ratings, it is advisable to review the issuing firm's rating scale, in order to fully understand the meaning behind each term.
Mapping the Basics
For now, let us dissect the traditional ratings of "sell," "underperform," "hold," "outperform," and "buy," and assume that each firm, no matter how wacky the system, can map back to these.
- Buy:Also known as strong buy and "on the recommended list." Needless to say, buy is a recommendation to purchase a specific security.
- Sell:Also known as strong sell, it's a recommendation to sell a security or to liquidate an asset.
- Hold:In general terms, a company with a hold recommendation is expected to perform at the same pace as comparable companies or in line with the market.
- Underperform:A recommendation that means a stock is expected to do slightly worse than the overall stock market return. Underperform can also be expressed as "moderate sell," "weak hold," and "underweight."
- Outperform:Also known as "moderate buy," "accumulate," and "overweight." Outperform is an analyst recommendation meaning a stock is expected to do slightly better than the market return.
If you are investing like Warren Buffett, the report can assist in finding the company with a durable competitive advantage, and if Peter Lynch is your hero, you might find a low P/E ratio, share buyback, or future earnings growth candidate in the depths of the report.
The research report and subsequent rating should be used to complement individual homework and strategy.
Real-World Examples of Analyst Ratings and Performance
In order to truly understand analyst ratings, it is imperative to gauge their accuracy. Below are three crucial moments in the lives of three well-known companies and the analyst ratings before their impressive liftoff, or dismal implosion, to see if the analysts got it right.
Coca-Cola
Coca-Cola Co. (KO) is the world's largest nonalcoholic beverage company.
The Crucial Moment
On July 30 of 2010, co*ke bubbles over in a frenzy, rising from $17.39 to $32.75 on Dec. 30, 2010, a 88 % increase.
The Analyst Recommendation
On March 4, 2010, UBS upgraded its recommendation for co*ke from a "neutral" to a "buy."
Conclusion: Score one for the analyst!
Starbucks
Starbucks (SBUX) keeps the world caffeinated through a global chain of more than 30,000 company-owned and licensed stores.
The Crucial Moment
From Oct. 1, 2006, to Dec. 1, 2008, Starbucks plummets from $18.88 to $4.73—a nearly 75% fall. This double shot of drop can be partially blamed on recessionary pressures, but the company is also suffering from whole-roasted over-expansion.
The Analyst Recommendation
A slew of analysts' recommendations came out that fall and winter from Friedman Billings Ramsey, UBS, and Robert W. Baird. Both Friedman and Baird initiated coverage with a rating of "outperform." Only UBS downgraded the stock from "buy" to "neutral" on Oct. 10, 2006, but two months later they upgraded to a "buy."
Conclusion: Missed the mark.
Apple
Apple Inc. (AAPL) designs consumer electronic devices, including personal computers (Mac), tablets (iPad), phones (iPhone), and portable music players (iPod).
The Crucial Moment
Starting on Dec. 9, 1998, Apple stock starts climbing from a low of $0.29 to a (then) all-time high of $1.12 on March 30, 2000.
The Analyst Recommendation
During the spring to fall of 1998, two firms, Bear Stearns and J.P. Morgan, upgraded their recommendations to "buys," Robert Cohen downgraded to a "neutral," and three others initiated coverage with two "holds," a "buy," and a "neutral." For those keeping score at home, that's three buys, two holds, and two neutrals.
Conclusion: The tie goes to the runner or in this case, the analysts. Although not all jumped on the "buy" bandwagon, no "sells" bubbled up, and overall, the ratings skewed to the buy side. So, advantage, analysts.
Who Issues Stock Recommendations: Buy-side or Sell-side Analysts?
Sell-side analysts work at investment banks and are the ones who will issue recommendations of "strong buy," "outperform," "neutral," or "sell." Buy-side analysts instead work for investment firms or funds and choose investments that coincide with the fund's investment strategy.
Why Are Some Recommendations Made as "Outperform" and Others as "Buy"?
Among sell-side firms, there is no standardized recommendation system, with different investment banks using their own internal rating scale. Thus, one bank may issue a "buy" rating that is equivalent to another bank's rating of "outperform." In both cases, the analysts have determined that the stock in question should have returns in excess of the broader market.
Should I Sell a Stock I Own If It Receives an Analysts Rating of "Sell"?
Analysts' ratings are arrived at based on fundamental and econometric analysis of a company and its future prospects. But, analysts can sometimes be wrong or make a mistake. As a result, you will want to consider the consensus of recommendations from several professional analysts. If they all (or mostly) recommend "sell," you may want to consider reducing or closing out your position in that stock,
