What is meant by a buy rating?

An analyst’s rating is intended to provide guidance for investors about the direction of price movement regarding an asset (such as a stock or bond). In the case of a buy rating, an analyst is indicating that the price of an asset is likely to move higher over a period of time. Since many analysts issue ratings that coincide with a company’s release of their quarterly earnings, an analyst may issue four ratings every year. A buy rating that is reinforced over more than one period is considered stronger than when a stock receives a buy rating that is one quarter that is downgraded the next quarter.  Also, while a buy rating is the highest rating for many analysts, some analysts will issue an even more bullish strong buy rating based on different criteria.

To come up with their rating, an analyst will take a close look at a company’s financials. By looking at metrics such as their free cash flow and debt picture, they can get a better picture of what a company’s earnings report means.

Obviously, an analyst will issue a buy recommendation because they have reason to believe that the asset they are reviewing is projected to increase in price. Depending on the classifications that analysts use, a buy rating may require an analyst to perceive a large price movement or maybe just a small to moderate price movement.

Some of the reasons an analyst may have expectations for a stock to increase in price include:

1. A positive earnings estimate. In many cases, this doesn’t necessarily mean their revenue, profit, or earnings per share (EPS) have to “blow away” Wall Street. Sometimes, a stock that is in a volatile industry simply needs to show that it is on track to meet, or slightly exceed, its forecast for analysts to reward it with a buy rating.
2. The announcement of a dividend increase. For income-oriented investors, the announcement of a dividend, particularly when it will be increasing, will often cause a stock price to increase as investors rush in to be invested in the stock before the ex-dividend date.
3. A change in government policies. For heavily regulated companies and industries, a decrease in regulations can cause the stock to get a short-term lift. Elections are also a reason for stocks to rise. In recent years, cannabis companies have seen their stock price rise as more states have had ballot initiatives that have legalized medicinal and/or recreational marijuana use. Favorable tax policy is generally a bullish sign for many stocks.
4. New product development or a breakthrough technology – in the telecommunications industry, the explosion of 3G, 4G and soon 5G technologies has created tremendous opportunities for the companies that provide the hardware and distribution necessary to support this technology.
5. Growth in a particular sector – This fits under the heading “a rising tide lifts all boats”. However, this rising tide can turn into a bubble and when a stock is growing due to a “halo” effect of being in the right sector, investors should proceed with caution – even if the stock has a buy rating. At the turn of the century, internet stocks were all the rage. However, when the bubble burst many investors were left with their portfolio in shambles.

This is one of the most debated issues over time. How much can an investor trust an analyst’s rating? Prior to the year 2000, many of the firms that analysts worked for were unregulated which created the opportunity for many analysts to give ratings that reflected a conflict of interest. Since the tech bubble burst, the Sarbanes-Oxley Act of 2002 has brought more transparency to the industry. However, no two buy ratings are guaranteed to mean the same thing. Depending on the firm they work for, analysts use either an absolute or a relative rating system.

In an absolute rating system, the analyst is assessing whether a stock will go up or down by a specified amount over a specified period of time. This period of time can be a year or even longer. It is not necessarily an indication that the stock will go up the day after the analyst’s rating is released.

In a relative rating system, the analyst is assessing how the stock will perform in relation to an index or other market benchmarks. In this context, a stock that is forecast to drop 20 percent in a sector that is expected to drop 50 percent would be considered a buy.

Although a buy rating is generally perceived as a positive sign for a stock, it might surprise investors to know that a buy rating should not be taken as an absolute recommendation for an investor to pour money into a stock. An analyst, whether on the buy side or the sell side is usually assigned to a specific sector or industry. This means that the scope of the stocks they are analyzing is limited to that sector. Income-oriented investors may find high-growth tech stocks too aggressive for their portfolio. Likewise, while a blue-chip dividend stock may be a great value, it may not offer more aggressive investors the capital growth they desire. This reinforces the limitations of an analyst’s rating. While they can be an important piece of analyzing stocks, an analyst’s rating is only one piece. In addition to an analyst’s rating, investors need to take into account their investment goals, risk tolerance, investment style, their time horizon, and where the stock fits into their portfolio. These additional considerations are addressed by institutional investors who, in addition to stock analysts, employ portfolio analysts and financial advisors.

For example, if an investor has a portfolio that is currently overweighted in stocks, an investor may have to consider selling some stocks before adding another stock. They may also have to consider the industry. If the stock is the leader of a poorly performing sector, it may be better to pass on it. For investors to make these determinations require different valuation analyses that are apart from the analyst rating on the stock’s price movement.

Also, consider that the idea that a stock will be rising in price, while being a buy signal for some investors may be a sell signal for others. Some stocks may only be suitable for the most aggressive investors – and even then, they may only be suitable for a small subset of that category. Investors who are comfortable with more risk may engage in the practice of short selling a stock. Short selling is, by definition, investing in a security with the expectation of the security moving down in price. This is an advanced trading strategy that requires trading with a margin account (i.e. borrowing money from a broker). For short sellers, a consensus buy rating will be a reason to avoid attempting a short sale as there is theoretically no limit to the amount of money an investor can lose if a stock increases when they have taken out a short position.