What is meant by a buy rating?

Posted on Tuesday, June 11th, 2019 MarketBeat Staff

Summary - A buy rating is given by analysts when they anticipate that an asset’s price will be moving above its current level over a period of time. It is one of the least ambiguous of all the analysts’ ratings.

Many analysts issue their ratings every quarter to coincide with a company’s release of their earnings reports. Although some analysts stick to the traditional “buy”, “hold”, or “sell” ratings, other analysts have moved to other classifications that offer more nuances into how the analyst perceives the stock. Whether the analyst is on the buy-side or the sell-side, their credibility is somewhat dependent on the quality of their analysis. For this reason, some analysts shy away from giving trading signals such as “buy” and instead choose ratings such as overweight or overperform to describe what is going on with the price while falling short of making a specific recommendation.

Buy ratings are issued independently of what is taking place in the broader stock market. For example, utility stocks tend to perform well in any market because they offer something that is always needed by consumers. Likewise, defensive stocks such as those of grocery store chains and pharmaceuticals tend to perform well in any market, including bear markets. In bull markets, growth stocks – such as technology stocks – will tend to perform well as investors will be more accepting of risk in their portfolio.

A buy rating is a projection for upward medium to long-term price movement and is usually applied in absolute or relative terms. When a buy rating is considered absolute, the stock is forecast to grow by a particular amount over a period of time. A stock can experience a short-term decline in price, particularly when looking at volatile growth stocks. These stocks, however, offer the possibility for a larger gain. A relative buy rating is forecasting a stock against an index or other industry benchmarks. This can mean that a stock that declines 10 percent while its corresponding index is forecast to decline by 20 percent will receive a buy rating.

Introduction

Investing would be easy if investors were given a list of stocks to buy, the price at which to buy them, and how long to hold them. In reality, investing can be a complicated mix of all three of those factors. One data point that investors have come to rely on is the analyst ratings for a security, usually some form of equity like a stock, bond, mutual fund or exchange-traded fund (ETF). The standard ratings are Buy, Hold, or Sell. However, in recent years, as investors have demanded more meaning behind a rating, analysts have taken to use other descriptions such as Overperform, Market Perform or Underperform to describe expected price movement. In this article, we’re going to take a close look at the Buy Rating. Although this is one of the least ambiguous of all ratings, we’ll explain why it is not intended to take the place of an investor’s own research as they consider what is best for their portfolio. Continue reading to learn more about what an analyst is really saying when they give a stock a buy rating.

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.

What are some reasons analysts would give stocks a buy rating?

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.

How accurate are an analyst’s ratings?

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.

Is a buy rating a buying recommendation?

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.

The final word on a buy rating

Stock analysts play a specific role in the stock picking process. The most visible is in their assignment of a “rating” to the stocks that they cover. A buy rating means that an asset is expected to increase in price either in absolute terms – meaning it will go up a certain amount over a defined period of time, or it will outperform some industry benchmark. While a buy rating is generally considered to be a favorable rating, investors must take care to understand what a buy rating means as well as considering other factors like their own risk tolerance and the composition of their portfolio before deciding whether or not to buy that stock. In fact, individual stock analysis is the last, and some would argue, the least important factor in investment decisions.

 

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