Analyst ratings: how to use them

What are analyst ratings?

Professional equity analysts, or the firms they work for, sell research for a living.

Analysts ‘cover’ a number of companies ranging from a handful to 20 or 30, depending on how large their team is and which sector they focus on. 

For example, the US software industry is large and diverse, so a US software analyst might cover up to 30 businesses.

The UK telecommunications sector, by contrast, is somewhat narrower, with only a handful of companies in existence. That makes for a much lighter workload for the researcher. 

In its broadest sense, coverage means conducting ongoing research and maintaining a current ‘view’ on a company and its stock price.

In practice, analysts produce research content that is distributed to clients. Content can be anything from a review of recent earnings, to a deep dive on a particular aspect of a firm’s business model.

The tag line attached to this content is a rating that signals the analysts’ current view of a particular stock.

Ratings are designed to squeeze reams of research into a single actionable output for investors: usually buy, hold or sell.

In reality, these action points come in different shapes and sizes. A positive view might be headlined with a buy, outperform or overweight, for example. 

In that instance, while each word might mean something slightly different, they all indicate a positive view and a belief that a stock will deliver better than average returns in the future.

The opposite is true for sell, underperform or underweight. 

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How are ratings calculated?

Along with research content production, the other key task for an analyst is to maintain a stock valuation model. 

Models detail financial projections and a valuation framework, a key output of which is a stock price target.

A price target is what the analyst thinks is a fair price for the company, and it drives the official rating. 

If the analyst thinks the fair price is meaningfully above the current price, then they will attach a buy (overweight/outperform) rating to the stock.

And again the opposite with analyst ratings of sell (underweight/underperform).  

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Bad company, good stock

A buy (or sell) rating doesn’t always mean the analyst thinks the company is good (or bad). Good companies can make for bad investments, and vice versa. 

The question an analyst’s answering is whether a firm’s prospects, good or bad, are accurately priced in or reflected in its current stock price. 

An analyst could have a favourable view of a business and its future prospects, but calculate a target price that is below the current market price. 

So that would be a sell rating? Not quite.

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Hold means sell?

Take a glance at the chart below from FactSet which shows the buy/hold/sell rating split for the S&P 500 back to 2010.

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Two things should jump out:

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1. Buy ratings usually represent more than 50% of the split
2. Sell ratings are never above 10%

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This is because stock markets and their constituents tend to rise more than fall over time. A sell rating (as opposed to an underperform/underweight, more on that below) can mean only one thing: the analyst thinks the stock is overvalued, and it will fall.

But a rising stock market tide tends to lift its constituent boats, and going against that tide with a sell rating can be a career damaging call.

Instead, analysts might be more inclined to plump for a fence-sitting hold rating, meaning they don’t recommend investors put more cash in at these levels.

The punchline is that if hold ratings outnumber buy ratings, it might indicate a consensus view that is less benign than a hold tag might imply. As if everyone wants to say it but no one will.

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Other things to watch: absolute or relative

While we and others present ratings under buy/hold/sell headings, their cousins overweight/outperform, neutral/marketperform and underweight/underperform mean slightly different things. 

Here the analyst is suggesting a rating relative to something else like an index such as the S&P 500. 

Overweight/outperform in this case means the analyst thinks the stock will outperform on a relative basis, with underweight/underperform meaning the opposite.

The most important thing to consider with relative ratings is an underweight or underperform doesn’t necessarily mean the analyst thinks the stock is going to fall. 

Unlike a sell rating which usually means the analyst thinks the stock will fall, an underperform can be accurate if the stock goes up less than the index against which the analyst is measured.

In that case, it’s still going up, just not quite as much as the index did.

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If it walks like a duck

At a high level, while it’s important to understand the nuances, if a stock has a high percentage of buy ratings, more analysts think the stock will go up than think it will go down.

And while rare, the opposite is also true. 

What analysts think, though, should only be one input into your research process. They may be professional and compensated accordingly, but they are often wrong.

If you buy the first house you see because a professional estate agent tells you to, then analyst ratings might be your holy grail. 

But we suspect you don’t part with your cash that easily for property, so neither should you when investing in shares. Analyst ratings have their place, but they aren’t a one stop shop.

So, as with other metrics and measurements, analyst ratings can be part of the stock picking process, but they shouldn’t be the whole thing.

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