Stock analysts use many different words to describe their ratings.
They commonly use the terms buy, sell, or hold, which are easy to understand.
But other analysts use more confusing terms like strong buy, outperform, overweight, underperform, underweight, and several others.
This article explains what all the different ratings mean and how you can use them to make better investing decisions.
What stock analysts do
A stock analyst is a person who works for a financial firm or investment bank. Their job is to analyze companies and decide whether their stocks are worth investing in.
They analyze financial statements, listen to quarterly conference calls, and may also get in direct contact with a company's management and key customers.
In addition, analysts often do surveys and various types of research that give them information on how well a company is doing.
After they complete their research, they give a rating (buy, sell, hold, etc.) and a 12-month price target -- as in, what they think the stock price will be at in a year.
The analysts then typically release extensive research reports on the stocks, along with predictions for earnings per share (EPS) and revenue for the coming quarters and years.
You may be able to get access to these research reports through your brokerage company or investment bank.
Despite analysts often being wrong, many institutional investors and regular investors use their ratings and reports when making investment decisions.
Because of this, the ratings and price targets from stock analysts often lead to big price movements in individual stocks.
What the most common analyst ratings mean
Many analysts like to keep things simple and only give buy, hold, or sell ratings:
- A buy rating is a recommendation to buy the stock.
- A sell rating is a recommendation to sell or even short the stock.
- A hold rating is netural. There is no reason to buy the stock, but if you own it then there's no compelling reason to sell either.
However, some analysts use different terms to describe their ratings, which makes it confusing to interpret what they mean.
For example, what's the difference between a "buy" and an "outperform" rating? Or a "sell" and an "underperform" rating?
To simplify, all the different analyst rating terms can fit into five general categories:
- Buy: Sometimes called "strong buy," a buy rating is bullish and implies that the stock is likely to perform very well.
- Outperform: Also termed "overweight" or "moderate buy." Outperform is a mild buy rating and implies that the stock is likely to have higher returns than the overall stock market.
- Hold: A hold rating is a neutral rating, often called "market perform" or "equal weight." This rating says there is no reason to buy the stock, but no particular reason to sell it either.
- Underperform: Also termed "underweight" or "moderate sell," an underperform rating means that the stock is likely to perform slightly worse than the market as a whole.
- Sell: Sometimes called "strong sell," a sell rating is pretty rare and usually only given if the analyst is extremely bearish on the stock. This rating implies that the stock should be sold or even shorted.
If you want to understand exactly what an individual rating means, then you need to look up the analyst's firm to find the official definition.
When an analyst changes a previous recommendation, that is called an upgrade or downgrade. For example, changing from hold to outperform is an upgrade, while a change from buy to hold is a downgrade.
When a stock gets upgraded or downgraded by an analyst, it often leads to a significant price movement.
Analyst rating averages
Websites that aggregate stock analyst ratings often give stocks a score of 1-5.
The weighting of the ratings is 1 for buy, 2 for outperform, 3 for hold, 4 for underperform and 5 for sell.
If the average rating is close to 5, that means that most analysts rate the stock as a sell.
But if the average rating is close to 1, then most analysts have a "buy" or "strong buy" rating.
Should you invest based on analyst ratings?
Analysts are frequently wrong, so you should be cautious when interpreting their ratings and recommendations.
Do not take isolated media reports about analyst ratings seriously. The financial media often makes a big deal out of them to get clicks, but a single rating from a single analyst doesn't matter much.
Stock analysts may also have a conflict of interest. In some cases, the firms they work for have positions in the stocks, which could have effects on the ratings.
You should absolutely not buy or sell stocks based only on what stock analysts say. It is crucial to do your own research and come to your own conclusions.
Analyst projections for revenue and EPS are often quite accurate. But their buy/sell/hold recommendations and price targets are not reliable at all.
This doesn't mean that analysts are bad at their jobs. Instead, it reflects how incredibly hard it is to predict what stock prices do in the short-term.