Understanding Analyst Ratings

In order to reach an opinion and communicate the value and volatility of a covered security, analysts research public financial statements, listen in on conference calls and talk to managers and the customers of a company, typically in an attempt to come up with findings for a research report.

Ultimately, through all this investigation into the company's performance, the analyst decides whether the stock is a "buy," sell," or hold." The question remains, however, is whether or not these recommendations are worth their salt? (For background on how research reports are generated, see "Analyst Recommendations: Do Sell Ratings Exist?")

The analyst ratings scale is a tad trickier than the traditional classifications of "buy, hold and sell." The various nuances, detailed in the following chart, include multiple terms for each of the ratings ("sell" is also known as "strong sell," "buy" can be labeled as "strong buy"), as well as a couple of new terms: underperform and outperform.

To top it off, not every firm adheres to the same ratings schema: an "outperform" for one firm may be a "buy" for another and a "sell" for one may be a "market perform" for another. Thus, when using ratings, it is advisable to review the issuing firm's rating scale, in order to fully understand the meaning behind each term.

For now, let us dissect the traditional ratings of "sell," "underperform," "hold," "outperform" and "buy," and assume that each firm, no matter how wacky the system, can map back to these.

• Buy: Also known as strong buy and "on the recommended list." Needless to say, buy is a recommendation to purchase a specific security.
• Sell: Also known as strong sell, it's a recommendation to sell a security or to liquidate an asset.
• Hold: In general terms, a company with a hold recommendation is expected to perform at the same pace as comparable companies or in-line with the market.
• Underperform: A recommendation that means a stock is expected to do slightly worse than the overall stock market return. Underperform can also be expressed as "moderate sell," "weak hold" and "underweight."
• Outperform: Also known as "moderate buy," "accumulate" and "overweight." Outperform is an analyst recommendation meaning a stock is expected to do slightly better than the market return.

Should an investor react accordingly to new analyst's recommendations and adjust a position based on the analyst's rating alone? Of course not. The research report and subsequent rating should be used to complement individual homework and strategy.

If you are investing like Warren Buffett, the report can assist in finding the company with a durable competitive advantage, and if Peter Lynch is your hero, you might find a low P/E ratio, share buyback or future earnings growth candidate in the depths of the report.

In order to truly understand analyst ratings, it is imperative to gauge their accuracy. Below are three crucial moments in the lives of three well-known companies and the analyst ratings before their impressive lift-off, or dismal implosion, to see if the analysts got it right.

Round One: Coca-Cola
Coca-Cola Co. (KO) is the world's largest nonalcoholic beverage company.

The Crucial Moment
Starting July of 2010, Coke bubbles over in a frenzy, rising from $50.05 to $65.77 on Dec. 31, 2010, a 31 % increase, reaching a new five-year high.

The Analyst Recommendation
On Mar. 4, 2010, UBS upgraded its recommendation for Coke from a "neutral" to a "buy."

Conclusion: Score one for the analyst!

Round Two: Starbucks
Starbucks (SBUX) keeps the world caffeinated through a global chain of more than 17,000 company-owned and licensed stores.

The Crucial Moment
From Oct. 31, 2006, to Nov. 30, 2008, Starbucks plummets from $38.35 to $8.93 – a 77% fall. This double shot of drop can be partially blamed on recessionary pressures, but the company is also suffering from whole-roasted over-expansion.

The Analyst Recommendation
A slew of analysts' recommendations came out that fall and winter from Friedman Billings, UBS and Robert W. Baird. Both Friedman and Baird initiated coverage with a rating of "outperform." Only UBS downgraded the stock from "buy" to "neutral" on Oct. 10, 2006, but two months later they upgraded to a "buy."

Conclusion: Missed the mark.

Round Three: Apple
Apple Inc. (AAPL) designs consumer electronic devices, including personal computers (Mac), tablets (iPad), phones (iPhone) and portable music players (iPod).

The Crucial Moment
Starting on Dec. 9, 1998, Apple stock starts climbing from a low of $7.91 to a (then) all-time high of $33.95 on Mar. 31, 2000.

The Analyst Recommendation
During the spring to fall of 1998, two firms, Bear Stearns and J.P. Morgan, upgraded their recommendations to "buys," Robert Cohen downgraded to a "neutral" and three others initiated coverage with two "holds," a "buy" and a "neutral." For those keeping score at home, that's three buys, two holds and two neutrals.

Conclusion: The tie goes to the runner or in this case, the analysts. Although not all jumped on the "buy" bandwagon, no "sells" bubbled up and overall, the ratings skewed to the buy side. So, advantage, analysts.

Analysts' recommendations are the fountainhead of equity research reports and should be used in tangent with proprietary research and investment methodologies in order to make investment decisions. Additionally, "buy, hold and sell" recommendation meanings are not as transparent as they first seem; a plethora of terms and variance in meanings exist behind the curtain and serve to muddy the waters. It is thus important to understand a firm's entire scale when assimilating ratings. (For more, see "Should You Listen to Stock Analysts?")