How do you pick what stocks you invest in? Do you look at a company’s price chart? Do you try to predict people’s future needs (for example, investing in hearing aid companies because you think we’re all going to get hearing damage from our loud music)?
There are many ways people make investment decisions, and even professional investors often rely on gut instinct for their choices. But there is one tool that most experienced investors rely on: analyst ratings.
They’re not hard to understand, but they do contain more information than you think. An experienced investor knows how to judge analyst ratings, and more importantly, when to ignore them.
Let’s teach you to do the same.
When analysts examine a stock, they take in all the public data the company releases, plus any information they can glean from talking to the executives in earnings calls (basically, like a press conference after quarterly earnings, but for analysts). They make some guesses on those comments — if an executive says they’re expecting “moderate” growth in the next quarter, an experienced analyst might know that usually means between 2% and 4% for that specific company — and put it all into a model. At the end, they come out with an estimate for where the stock price should be. That’s the price target, a very important part of analyst ratings.
From there they decide whether the stock will perform better, worse, or in line with the broader market. If they think it’ll do better, they give it a buy rating. If worse, they’ll give it a sell rating. If it’s about the same, it gets a hold rating. This is their recommendation to the investors that read their research: buy the stocks with buy ratings, sell the stocks with sell ratings. If a stock has a hold rating, they’re recommending you should hang on to what you have, but not buy any more, nor sell what you’re holding.
Let’s take a look at an actual rating in the Vivid app, for Zoom Video Communications. This is just as an example — the information here is likely outdated by the time you read it.
What you’re seeing here is an amalgamation of a bunch of analyst ratings. Rather than take the recommendation of one analyst, we collect recommendations from many and average them out. This is very common in the financial industry — the idea is that one analyst can be wrong, but it’s far less likely for all of them to be wrong.
The bars show you what percentage of analysts recommended what action. In Zoom’s case, exactly half of the analysts had a hold rating, while 46% had a buy or strong buy rating (some analysts have strong buy ratings for stocks they think are particularly promising, but this isn’t a universal thing.)
At the bottom, you can see the average price target, and the current price. For Zoom, most analysts think the shares are worth 426 — much higher than the 327 they were worth at that moment.
So does that mean the price is going to reach 426? Not quite.
This may come as a surprise, but financial analysts make wrong predictions all the time. There are tools that track individual analysts and their predictions, and calculate what kind of a return you would have gotten had you followed their advice. The results tend to be all across the board, even for analysts with decades of experience. Though some may have spectacular results, others may fail wildly.
That’s one of the reasons investors prefer to look at averages — it’s less likely that all analysts will be wrong about a stock than a single analyst will. But that doesn’t mean it’s impossible.
Another thing to keep in mind — analysts tend to base their price targets on current information. That is to say, they can’t see the future. The world can change fast, and stock prices change even faster. Just before the coronavirus pandemic, no analyst was really factoring in a global health catastrophe into their models. A company like Zoom wasn’t even on their radar. It’s only after the pandemic hit that they began adjusting their models.
Still, if you haven’t followed a company closely, an average of analyst reports can be like someone doing most of the homework for you: you can trust that they’ve seen the numbers, know how the company is doing, and have a reasonable guess of where it’s going. Whether you believe they’re going to be proven right is, as always, up to you.
Any opinions, news, research, analyses, or other information contained on this website are provided as general market commentary, and do not constitute investment advice, recommendations nor should be perceived as (independent) investment research. The author or authors are employed by Vivid and may be privately invested in one or several securities mentioned in an article. Vivid Invest GmbH offers as a tied agent of CM-Equity AG the brokerage of transactions on the purchase and sale of financial instruments with the exception of those in the area of foreign exchange brokered by Vivid Money GmbH.