Financial analysts give their opinions of the future performance of a security. They can give performance ratings of underweight, overweight, or market perform to a security. If analysts give a stock an overweight rating, they expect the stock to outperform its industry in the market. Analysts may give a stock an overweight recommendation due to a steady stream of positive news, good earnings, and raised guidance.
- An overweight rating on a stock usually means that it deserves a higher weighting than the benchmark's current weighting for that stock.
- An overweight rating on a stock means that an equity analyst believes the company's stock price should perform better in the future.
- However, an analyst's rating needs to be taken into context with the investor's time horizon and risk tolerance.
Understanding Stock Ratings
Stock analysts are employed by investment firms whereby they are charged with evaluating the financial performance of a company. As a result of the analysis, the investment analyst makes a recommendation for the equity or stock, which is typically a buy, sell, or hold recommendation. However, the ratings that stock analysts provide are more involved than simply a buy or sell rating.
Below are the three most common ratings provided by stock analysts:
Typically, an overweight rating on a stock means that an equity analyst believes the company's stock price should perform better in the future. However, it's important that investors understand the benchmark that the equity analyst is comparing the stock's performance to when issuing the rating.
An overweight rating might be issued based on a benchmark index, such as the S&P 500, which is an index containing 500 of the largest publicly-traded companies in the U.S. In other words, an overweight rating on a stock means that the stock deserves a higher weighting than the benchmark's current weighting for that stock.
For example, let's say that Apple Inc. has a weighting in the S&P 500 of 5%, meaning Apple comprises of 5% of the total value of the index. An overweight rating on Apple would indicate that the equity analyst believes that Apple should have a larger or higher weighting than the current 5% weighting in the S&P.
A stock that has an underweight rating means that an equity analyst believes the company's stock price will not perform as well as the benchmark index being used for comparison. In other words, an underweight stock rating means it will generate a below-average return compared to the benchmark. As a result, the stock deserves a lower weighting than the benchmark's current weighting for that stock.
A stock that has an equal weight rating means that an equity analyst believes the company's stock price will perform in line or similarly than the benchmark index being used for comparison.
Overweight and Price Targets
Although an overweight rating technically means the stock should have a higher weighting in the underlying benchmark, it usually is interpreted by market participants that the company is doing well, and its stock price should move higher.
In other words, investors view an overweight rating as an indicator that the stock price should perform better than the performance of the overall index that's being used as the baseline for comparison.
If an analyst believes that a stock price should appreciate, the analyst will likely indicate the time frame and an expected price target within that time frame. For example, assume company ABC is in the biotech sector, has a drug for lung cancer, and is currently trading at $100 per share. The company releases positive data and receives FDA approval leading to a stock price increase by 25%. Analysts may give their opinion based on this news and rate the stock as overweight with a price target of $175 for the next 12 months.
Criticisms of Overweight Ratings
A criticism of overweight ratings is that equity analysts do not provide specific guidance as to how much of the stock should be purchased by investors. One investor might interpret an overweight rating as an indicator to buy 1,000 shares of the stock while another investor might interpret the rating differently and buy only 10 shares of the stock.
Also, the current position size of the stock that comprises an investor's portfolio plays a critical role in determining how many additional shares to purchase based on the new rating. If a stock currently has a large position within a portfolio and an investor buys more shares based on the overweight rating, the portfolio might not be diversified. In other words, the portfolio might be out of balance whereby too much of the investor's investment capital is tied up in one company. If the analyst turns out to be wrong, and the stock price goes down, the investor stands to lose more money because there's an overexposure to one stock.
The overweight rating provides a little guidance as to how specifically investors should go about purchasing the shares as it relates to their investment portfolio. Perhaps a portfolio that is heavy with technology stocks shouldn't purchase an additional technology stock based on an overweight rating since the portfolio could become out of balance.
It's important to consider that an overweight rating by some equity analysts might be a short-term trade. Investors should investigate how an analyst conducts their recommendations, determine what they're using as a benchmark, and whether their long-term or short-term investors.
The investment time horizon, including the investor's age, will likely determine how long a stock might be held in a portfolio. For example, a retiree might hold a stock for only a few months or years because it may need to be converted to cash at some point. A millennial, on the other hand, will have a much longer outlook or time horizon for holding that stock. The analyst's rating needs to be taken into context with the investor's time horizon, risk tolerance, and whether the money will be needed at some point in the future.
Example of an Overweight Rating
Analysts may give a stock an overweight rating due to positive earnings and raised guidance. For example, assume company DEF, a technology company, releases its quarterly earnings results and beats its earnings per share and revenue estimates. In addition, the company raises its full-year earnings per share and revenue guidance by 25%.
The stock price increases by 10%, after its earnings release, from $80 to $88 per share. Also, suppose the sector has been underperforming the market and the sector declines by 20% while company DEF's stock price increases by another 25% over the same period.
Since the stock is appreciating while the sector is depreciating, analysts give the stock an overweight and outperform rating with a price target of $150 because they expect returns to outperform the industry.