Analyst Rating

Why should I care about analyst ratings?

For markets: Analyst ratings can influence market movements and potentially impact stock prices as they’re closely watched by investors for clues about a stock's potential. For instance, a wave of "buy" ratings could boost a stock's value, while a string of "sell" recommendations could trigger a sell-off.

For you personally: Analyst ratings are just one piece of the puzzle but they can be a helpful heuristic as part of your overall research process, highlighting areas that could be worth focusing on and saving you hours in the process.

The bigger picture: Analyst ratings often reflect the broader macroeconomic outlook or sector-specific trends, offering a window into wider market dynamics. These ratings can be a canary in the coal mine for certain industries or sectors. For example, lots of analysts turning negative on oil stocks could indicate broader concerns about the future direction of oil prices. Keeping an eye on analyst ratings, then, can help investors keep up to date with broader trends beyond individual stocks.

Types of analyst rating

Positive: Analysts may issue a “buy”, “outperform”, or “overweight” rating on stocks they’re positive on. That might be because they believe the stock’s attractive overall or might just outperform its peer group or the broader market over the next period. Essentially, it’s a thumbs-up to investors.

Negative: Analysts may rate a stock “sell”, “underperform”, or “underweight” if they’re negative on it, either overall or compared to peers or the overall market.

Neither positive or negative: Analysts may issue a “neutral”, “market perform”, “equal-weight” or “hold” rating if they’re taking a wait-and-see approach or believe a stock is likely to perform in line with peers or the market.

How analysts determine ratings

Analysts use quantitative and qualitative approaches to shape their view on a given company, its prospects, potential future value and, as a result, its rating. The firms analysts work at will have differing frameworks for setting out their ratings, which partly depend on the types of institutional investors they’re focused on serving. Usually, research reports will explain how ratings are set in the legal disclosures.

Absolute rating systems

Rating stocks based on their absolute potential return is pretty straightforward. Firms may set out specific criteria that, when met, trigger a particular rating. Let’s say an analyst concludes a stock has 20% potential upside over the next year, that could trigger a “buy” rating – while one with 0-10% might be assigned “hold”. These systems are perhaps most helpful for investors who’re focused on absolute returns rather than beating a specific benchmark.

Relative rating systems

On the flip side, relative rating systems are more nuanced. In these systems, a stock’s potential upside or downside isn’t evaluated in isolation. Instead, its expected return is measured against a relevant benchmark or compared to other stocks that the analyst covers (usually other companies in the same industry).

So going back to our example stock with 20% upside: its rating would depend on the potential upside of other stocks in the analyst's investment universe or the expected return of the benchmark index. If the average potential upside for the peer group was 40%, say, our example stock might be rated neutral or indeed sell/underperform. This system reflects the reality for the majority of active institutional investors, whose aim is to beat their respective benchmarks. And while buy or sell ratings are helpful, they’re typically looking to identify stocks that will outperform or underperform key benchmarks.

How to use analyst ratings to make investment decisions

To use analyst ratings in your investment decisions, it’s important to look at them in a broader context. For instance, publicly available financial data sources may show ratings from multiple analysts. And let’s say 30 analysts have issued ratings on a stock, looking at the split of buy ratings versus neutral ratings versus sell ratings offers context about how investors might feel about it right now. Similarly, tracking any rating changes over recent months might help you catch shifts in sentiment that might signal a stock’s potential rise or fall.

Coupling analyst ratings with “price targets” – which are analysts' views on what the fair value of the stock will be at a specific future point in time, usually a year. Price targets are calculated from detailed analysis of historical financial performance, fundamental analysis, forecasting, and applying valuation methodologies that take market conditions into account – and offer a tangible potential “upside” or “downside” to the current share price.

Integrate any insights from ratings and price targets with your analysis from other data sources to help ensure you have a considered and balanced view.

Can you trust analyst ratings?

In short: not blindly. While analyst ratings can offer valuable insights, they come with caveats. At the firm level, potential conflicts of interest should make investors wary. Given investment banks often want to do business with the firms covered by their research analysts, there’s a tendency for analysts – although independent – to bias positively in their ratings for all companies. Sell ratings are typically rare: so rare that cynical investors may interpret neutral ratings as the closest an analyst is willing to get to issuing a sell rating. And at the individual level, ratings do not guarantee stock performance, and external factors can significantly influence actual outcomes. While some analysts may have a good track record, past performance doesn't guarantee future results. It’s therefore best to focus on understanding the analyst's reasoning behind the rating, not just the recommendation itself.

Frequently Asked Questions (FAQs):

What do analyst ratings mean?

They represent a one-word summary of an analyst's view of the potential attractiveness of a stock, either in absolute terms or relative to other opportunities out there.

Is an “outperform” rating good for a stock?

Yes, it indicates that an analyst believes the stock will rise more than the overall market or key benchmark in a given period.

Can analyst ratings affect stock prices?

Yes, these ratings can lead to price movements, especially when issued by influential analysts. A positive rating can boost investor confidence and drive up the price, while a negative rating can have the opposite effect. However, it's not always a straightforward cause-and-effect relationship.