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 capture the findings for a research report. Ultimately, through all this investigation into the company's performance the analyst decides whether their stock is a "buy," sell" or hold." The question remains, however, is whether or not these recommendations are worth their salt?
The Scale of Ratings
The analyst ratings 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.
Mapping the BasicsTo top it off, not every firm adheres to the same ratings schema: 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 understand the meaning behind the term.
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 market return. Underperform can also be lumped in with "moderate sell," "weak hold" and "under-weight."
- Outperform - Also known as "moderate buy," "accumulate" and "over-weight." Outperform is an analyst recommendation meaning a stock is expected to do slightly better than the market return.
Should an investor react accordingly to new analyst's recommendations and adjust a position based on the analyst's rating alone? Of course not. The research report and subsequent rating should be used to complement individual homework and strategy. If you are investing like Buffett, the report can assist in finding the company with the durable competitive advantage, and if Peter Lynch is your hero, you might find a low P/E ratio, share buyback or future earnings growth in the depths of the report.