If you've ever tried to decipher an equity research reports, you are likely familiar with the ratings used by analysts (such as buy, hold, accumulate, outperform/underperform, accumulate, neutral, overweight etc...) to sum up their opinion of a stock. But what do these terms actually mean to you? Most investors just want to know whether a stock is "good" or not, but how can an investment decision be reached when you practically need a dictionary to sort through the jargon?

In this article, we'll look at how to decipher the analyst rating system and discuss how useful analyst ratings are for the average investor.

The Background on Analyst Reports
A research analyst is a financial professional who researches investments and makes recommendations. Most people think of analysts as equity analysts who, as the name implies, research stocks (equities). In fact, analysts analyze everything from bonds to derivatives. In this article we'll be talking about equity analysts.

Analysts release their findings in research reports, which can be anything from one- or two-page summaries to detailed documents that are dozens of pages long.

An analyst report will generally contain the following items:

  1. A detailed description of the company and its industry, including relevant financial numbers.
  2. An opinionated thesis explaining why the analyst believes the company will succeed or fail.
  3. A target price for the stock over the next year (or two).
  4. A recommendation or rating.

Most analysts put plenty of work into these reports, often traveling to the company's headquarters and getting a first-hand tour of operations.

Not All Ratings are Created Equal
The bulk of an analyst's work is contained in the body of the research report. Despite this, the rating gets the lion's share of attention. It's easy to understand why: ratings are the sexy sound bites that can be easily repeated in the financial media. Plus, most investors don't have the time to sit down and read through a 20-page report.

The problem is that ratings scales are not uniform across Wall Street. At one brokerage, "buy" may be the strongest recommendation, while at another, "buy" could be second to a "strong buy" rating. The second-highest ratings also have a number of different other names: "accumulate," "outperform," "moderate buy" or "overweight." A similar mix of terms appears further down the scale, as the ratings become more negative. Finally, some brokerages use a number system to indicate their rating on a stock.

The chart below shows an approximation of where ratings fit in relation to each other:

Analyst stock recommendations

Buy, Buy, Buy
Even greater cause for concern than the complicated system of terms is the tendency of ratings to be buys (or at least positive). The reasons for this are ingrained in how the financial industry works.

The causes for the popularity of buy ratings are found in the relationships that result when brokerages provide investment banking services to large corporations. The bad news for retail investors is that the investment banking side of the business is very lucrative for brokerages. Their desire to please their potential investment banking clients creates a huge conflict of interest. Issuing negative research on the stocks of their own corporate clients may cost brokerages profitable business. In other words, a brokerage firm would rather be wrong on any buy/sell recommendation than be right and lose a corporate client.

The stake in issuing buy ratings is especially high when a brokerage firm is underwriting a company's offering of securities. Think of it this way: If a large brokerage just finished underwriting a technology company's IPO, would it seem logical for the brokerage's analyst to put a poor rating (such as a sell or market-underperform) on the stock? Of course not -a sell rating might even cost the analyst his or her job.

Other key sources of revenue in the financial industry are the fees and commissions brokerages charge to execute customer orders. Research reports touting the fabulous things to come for stocks can indirectly increase sales for a brokerage as clients buy more stock.

Also, remember that analysts are human, too. Conflicts can form when an analyst covers a company in which he or she (or friends and family) owns stock. An analyst's disincentive to put his or her own portfolio at risk could affect a decision about whether to release negative news.

We should mention that, on May 8, 2002, the Securities and Exchange Commission (SEC) made changes to the rules that govern some of the conflicts of interest we've mentioned here such as the matter of investment banking, analyst and firm compensation, personal trading by analysts and their family members etc. Changes were meant to protect individual investors in the wake of some of the analyst scandals following the dotcom meltdown. Some say the changes have resolved much of the problems; others say you can never completely free research from conflicts of interest.

What Good are Analyst Reports?
We've discussed the numerous terms analysts use to rate stocks, and why they so often reflect positively on companies. When you add all this up, does a buy rating mean you should purchase the stock? Probably not.

Realize that research reports and ratings are not meant to advise you personally. You'd think that the meanings of terms such as "buy" or "sell" are straightforward. Actually, firms emphasize that ratings are not advice and that investment decisions should not be made solely on an analyst rating. (Perhaps this helps explain part of the confusion in the differing rating scales.)

This disclaimer isn't a complete cop-out from the brokerage industry. Any decision to invest in a company is based not just on analysis of the stock but also on the investor's personal situation and strategy. A strong-buy rating for one investor might be a sell for another. A young executive might be totally comfortable with a risky high-tech stock that would be a terrible investment for a 90-year-old widower. Generally, you'd sit down with a financial planner to determine your risk tolerance, time horizon, asset allocation and so forth. The analyst doesn't know any of this information and thus can't make recommendations directly to you.

The Bottom Line
Although the analyst's rating is probably the most quoted part of a report, it may be the least useful. As a general rule, don't invest your money based solely on these recommendations. This doesn't mean that analyst reports are useless. Research reports can contain some great information, but use them only as a source of data that complements your research, rather than completes it.

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