After reading this article, you'll know what a "buy" or "overweight" rating means and how to put them to work for you.
What is a "buy" rating?
A "buy" rating is when analysts predict that certain stocks with strong buy rating are about to take off. Many of them issue their ratings every quarter to align with earnings reports, offering more detailed and nuanced opinions than "buy," "sell" or "hold."
A stock buy rating isn't always a signal that you should immediately run out and buy a particular stock – far from it. Other factors are at play, such as what sector or industry the stocks with buy ratings belong to. Of course, some stocks with strong buy ratings always perform: Utilities, defensive stocks and even tech in bull markets.
Stock buy ratings can come in absolute (e.g., predicting a certain growth percentage) or relative (for example, "overweight" or "overperform"). Professionals usually express a buy rating regarding expectations of the asset's medium-term or long-term performance and whether it will soar above its current value?
A relative rating forecasts a stock against an index or other industry benchmarks. It can mean that a stock that declines 10% while its corresponding index should decline by 20% will receive a "buy" rating. Even if a stock experiences a dip in value over a short period, this doesn't necessarily indicate a lack of long-term potential.
Other types of stock analyst ratings
There are several types of ratings used to evaluate stocks' potential performance. They include "sell," "hold" and "buy" ratings. Within those ratings, stocks can range from “strong buy” to “strong sell," with each term having its distinct meaning. Let's take a closer look at the three most common stock analyst ratings: "sell," "hold" and "buy."
Sell
A "sell" rating indicates that the analyst believes avoiding or selling a particular stock would be best. It's based on the belief that the price will drop significantly soon. Always take sell ratings seriously. They suggest that the analyst feels a stock should head for significant losses.
Hold
As the name implies, this suggests investors should wait and not buy or sell shares. It neither implies positive nor negative sentiment about a stock. Rather, it means that analysts feel there isn't enough information about the company or its industry to make an informed decision yet.
An "underperform" rating recommends avoiding buying or holding stock, as they expect it to perform worse than the overall market. While other stocks in its sector may be doing well, this particular stock is not likely to meet the same success. This rating may pop up when a company's financials are deteriorating or when there's news of certain risks associated with the company.
An outperform rating means an analyst believes that a stock will outperform its peers in its sector over the next 12 months. It's due to positive industry conditions or strong company fundamentals. If an analyst believes the current price of a stock doesn't reflect its true potential, they may rate it "outperform" to indicate that now is the time to buy it or hold onto it if you already own it.
Why analysts give stocks a "buy" rating
An analyst will issue a buy recommendation because they believe the asset will increase in price. They might perceive a significant price movement or a small to moderate one.
Some of the reasons an analyst may expect stocks with a buy rating to increase in price include:
- 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 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.
- The announcement of a dividend increase: For income-oriented investors, the announcement of a dividend, particularly one larger than before, will often cause a stock price to increase as investors rush to buy the stock before the ex-dividend date.
- 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 can also cause the highest buy rating stocks to rise. In recent years, cannabis companies have seen their stock price rise as more states have had ballot initiatives that have legalized medical or recreational marijuana use. Favorable tax policy is generally a bullish sign for many stocks.
- 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 to support this technology.
- Growth in a particular sector: While a rising tide lifts all boats, this rising tide can turn into a bubble, and when a stock grows due to a "halo" effect of being in the right sector, proceed with caution, even for stocks with highest buy rating. At the turn of the century, internet stocks were all the rage. However, many investors were left with their portfolios in shambles when the tech bubble burst.
How accurate are analyst ratings?
Analysts provide ratings for stocks to give investors an idea of how much potential a stock has and how it may perform in the future. But before 2000, many of the firms that analysts worked for were unregulated, which meant many analysts developed conflicts of interest and biases that influenced their ratings.
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. Although analysts' ratings are often valuable, they can also be controversial and unreliable.
Overall, analyst ratings are just one factor when considering whether or not to invest in a particular stock. Take them with a grain of salt and use other resources before deciding. Read up on a company's fundamentals and research its past performance.
Example of a buy rating
Let's look at an example of a "buy" rating on Hyatt Hotels Co. NYSE: H, one of the largest hotel brands in the United States. It currently has a consensus analyst rating of "moderate buy" with five analysts rating it as "buy," three rating it as "hold" and zero rating it as "sell."
It sounds like a strong recommendation, but you may want to further research the company before making a decision. One reason for these Hyatt analyst ratings is the company's strong fundamentals, including a solid balance sheet.
Additionally, Hyatt is expanding its Hyatt Place and Hyatt House brands in airports and other strategic locations around the U.S., investing in innovative technology to enhance the guest experience and focusing on sustainability initiatives.
Another factor that may have contributed to the "buy" rating is the current state of the hotel industry, which is rebounding now that travel restrictions have eased, and as one of the biggest U.S. hotel brands with a well-established reputation, Hyatt could continue to benefit.
While a "buy" rating is a positive signal, analysts can be wrong, and their ratings should not be the only factor you consider.
Let's take a look at another example: PayPal Inc. NASDAQ: PYPL, one of the earliest fintech companies. PayPal has a consensus analyst rating of "moderate buy" with 19 analysts giving it a "buy" rating, 11 analysts giving it a "hold" rating and only one giving it a "sell" rating.
This overwhelming positivity is due to several factors. Despite a post-pandemic dip in online shopping, PayPal has had generally consistent growth in revenue and profit over the past few years. Its digital payment platform has become increasingly popular. It has continued to innovate, adding new features and making acquisitions worth over $14.03 billion, including Venmo, which has allowed it to tap into a younger demographic who prefer mobile payments.
PayPal financials also show a large amount of cash on hand, granting the flexibility to invest in new technologies or make more acquisitions. The company has a strong competitive advantage due to its first-mover status in the digital payments industry and its established brand name.
Based on these factors, it's understandable why analysts have a positive outlook on PayPal, but keep in mind that even a "moderate buy" rating doesn't guarantee success and stock prices can still be volatile.
How to interpret "buy" ratings
When trying to interpret the buy ratings given by analysts for a particular stock, first look at the number of "buy" ratings versus "sell" or "hold." For example, if eight out of 10 analysts rating a company rate it as a "buy" and two rate it as a "hold," then consider this when determining whether or not to invest in that stock. Understanding why an analyst has rated a certain stock can help determine how reliable and accurate that analysis may be.
There are several potential reasons why an analyst might assign a stock a "buy" rating. One reason could be that the company recently announced a breakthrough technology or product development that can potentially drive profits.
Another reason could be that it operates in a growing sector or that favorable government policies or tax reforms may signal increased potential for growth.
Is a "buy" rating a buy recommendation?
Don't take a "buy" as an absolute recommendation. Analysts are usually limited to a specific sector or industry; thus, they only analyze stocks within that scope. Your goals, risk tolerance, investment style, time horizon and existing portfolio are just as important.
Institutional investors employ stock analysts, portfolio analysts and financial advisors to make their decisions; likewise, as an individual, you should also do your due diligence. For example, if you have an overweighted portfolio and the stock belongs to a poorly performing sector, it's probably a pass.
A stock's rising price can act as a buy signal for some investors and a sell signal for others. Some stocks may only be suitable for aggressive investors, even then possibly only those who short sell. Short selling means betting that a security will move down in price with borrowed money; if it rises instead, the investor loses. A consensus buy rating can deter a short seller.
Accuracy of buy recommendations
A 2012 global study conducted by the University of Waterloo and Boston College claimed that the trustworthiness and value of target prices were questionable, with many news outlets and fund managers labeling them as mere advertising. It determined that the accuracy of target prices typically did not exceed 18% for three months and 30% for one year.
This may come as a surprise; however, it's not hard to understand why these numbers can be so low. Analysts often don't have access or insight into a company's inner workings, such as product development plans or executive decisions. Timing is notoriously difficult in stock markets because one wrong assumption could lead to inaccurate predictions of how companies will perform. Many factors come into play, such as investors' sentiment toward the company, macroeconomic conditions and market movements, all of which may change after assigning a rating.
Going back to our example of PayPal, analyst predictions from over two years ago wouldn't consider any changes in the political winds or the post-pandemic economic conditions that have occurred since then - something analysts aren't usually able to account for. You need to consider analyst ratings as just one piece of information in your overall investment strategy and do your research.
Buying into analyst ratings
As an investor, analyst ratings are one of the most important tools in your arsenal. They can provide insight into companies and industries you wouldn't otherwise have and help you make informed decisions.
However, the accuracy of their recommendations is limited, and even a seemingly solid "buy" rating is never a definitive recommendation to buy any particular stock. They're just one piece of the puzzle in your overall investment strategy.
Before you consider Hyatt Hotels, you'll want to hear this.
MarketBeat keeps track of Wall Street's top-rated and best performing research analysts and the stocks they recommend to their clients on a daily basis. MarketBeat has identified the five stocks that top analysts are quietly whispering to their clients to buy now before the broader market catches on... and Hyatt Hotels wasn't on the list.
While Hyatt Hotels currently has a "Hold" rating among analysts, top-rated analysts believe these five stocks are better buys.
