Understanding Ratings

The part of an analyst report that tends to get the most attention is the rating — which also serves as a recommendation. The analyst assigns a rating to a stock as a way to sum up his or her opinion.

If an analyst believes a company will increase future earnings at a rate higher than its peers, the analyst gives the stock a high rating, or recommends that investors buy. If the analyst believes the stock isn’t worth buying at its current price, he or she may counsel investors to hold it — saying that it's neither hot nor cold. And if the stock looks set for a fall, the analyst may give it a low rating, or urge investors to sell.

Different scales

Some companies use rating scales with finer gradations between high and low to distinguish a stock that may be poised for disaster from one that may be only temporarily downtrodden, and to differentiate the stellar performers from those that are slightly better than average. Unfortunately, although these scales are meant to give the investor more information, they often end up causing more confusion, since the difference between a buy and a strong buy, for example, may seem arbitrary.

Furthermore, the language of ratings may not be as intuitive as buy and sell. For example, one firm refers to overweight, equal-weight, and underweight stocks in its research, while another prefers to rate stocks using the terms outperform, in-line, and underperform. And two analysts may use the same terms to mean different things. You may have to read the firm's explanation carefully to understand what its ratings really mean.

Ratings in context

Ratings sometimes make the news. When an analyst changes a stock's rating for the better, it's called upgrading the stock, and lowering a rating is called downgrading. When a respected analyst downgrades or upgrades a stock's rating, many investors take that advice seriously — both because they respect the analyst's opinion and because they know that the market will react to the rating change.

On the other hand, if you're an investor who's looking for value you might take the opportunity to buy a downgraded stock after prices dip, if you believe that the stock could turn around. This may also be true if you have a contrarian style of investing — buying when others sell, and vice versa. And long-term investors may not worry so much about changes to ratings, unless the situation is particularly dire.

What's the latest?

Because the analyst reports you review may be a few months old, you may need to examine them in light of the latest news and price movements to determine if the analysis still holds firm. For example, if an analyst has downgraded a stock because the price-to-earnings ratio (P/E) is too high — in other words, the stock seems overpriced — selling in the stock may have brought the P/E down to a more reasonable level.

In fact, you might entirely disagree with the analyst's recommendation. You may decide a stock is right for your portfolio now, even if an analyst recommends that you wait for a better price. That's why some investors prefer to look beyond a report's rating and use more of the supporting research to make their decisions.

Target price

If you're considering buying a stock in hopes of selling it later at a profit, one of your top priorities is to evaluate whether you believe the price will go up or down, and by how much. Therefore, the analyst's target price is considered by many investors to be as important or even more important than the rating.

The target price tells you what the analyst believes the stock price will be a year from now. It may be a single price or a range of prices, with an estimated high and low for the period.
Pros and cons

You may find target prices a more useful measure of a stock's potential than ratings, since ratings, by nature, are generic, across-the-board recommendations that don't take your particular portfolio needs into account. A target price can help you calculate whether a stock is worth its current market price given its estimated future performance. However, target prices are based on estimates that may not turn out to be accurate. Furthermore, if your financial needs are more long term, an attractive target price for next year may not be the best indicator of a stock's potential for long-term growth.

Courtesy: Pathtoinvesting.org