What it means
Investment banks and research firms publish ratings to summarise their view on a stock. Typical scales run from strong buy through buy, hold and sell to strong sell, though each firm uses its own wording, such as outperform or overweight.
A strong buy sits at the top of the scale and signals the analyst's highest conviction. The rating is normally tied to a price target, which is the analyst's estimate of what the share should be worth in about twelve months.
If the target is far above the current price, the analyst is more likely to call the stock a strong buy. The analyst also explains the reasons, such as faster growth, a cheap valuation or a new product.
Ratings are aggregated into a consensus, and the average is often shown as a number. Finance teams in listed companies watch the consensus, because a run of upgrades or downgrades can influence the share price and the cost of raising money.
Investors use ratings as one input, not as an instruction. A few cautions apply.
Analysts work for firms that may also earn fees from the companies they cover, which has historically produced a bias towards optimistic ratings. Strong buy ratings are also far more common than strong sell ratings, so the scale in practice is skewed upwards.
Ratings can change quickly after new results or news, and they often lag price moves rather than lead them. Because every firm defines its categories differently, a strong buy at one firm can be equivalent to a plain buy at another.
A careful reader looks at the reasoning and the assumptions behind the rating, not only the label.
In practice
Real-world examples.
Example
A broker publishes a strong buy on a small medical device company trading at $20 and sets a price target of $32. The note says new hospital contracts will lift sales by 25% a year. The target implies a 60% gain, which is why the rating is the highest rather than a plain buy.
Example
A company's investor relations manager sees that three of eight covering analysts have upgraded the stock to strong buy after a strong quarter. She prepares the chief financial officer for questions about whether the rally has already priced in the good news. The board uses the discussion when deciding whether to raise capital.
Example
A retail investor screens for stocks with an average rating below 1.5. She finds a long list and realises that the rating alone does not tell her about risk or timing. She uses it only as a starting point for her own research.
Formula
Calculation
Average consensus rating = sum of (number of analysts at each rating x score of that rating) / total number of analysts
Suppose a data provider scores a strong buy as 1, a buy as 2 and a hold as 3, and 10 analysts cover a stock. Five rate it strong buy, three rate it buy and two rate it hold. The total score is (5 x 1) + (3 x 2) + (2 x 3) = 5 + 6 + 6 = 17. The average rating is 17 / 10 = 1.7, which sits between strong buy and buy. Scales differ between providers, and some use 5 as the best score, so the direction must always be checked.Case study
Seen in the real world.
Harlow Robotics is an illustrative, fictional listed company whose shares traded at $25. After the company won a large supply contract, two brokers upgraded it to strong buy, citing earnings growth and a conservative balance sheet. The shares rose 12% in a week.
The chief financial officer then used the upgrades in a share-based acquisition, because the higher price meant fewer new shares had to be issued. The treasury team noted, however, that one of the brokers also advised on the company's bank refinancing.
Within a few months a competitor announced a rival product and the shares gave back most of the gain. The illustrative lesson is that a strong buy rating can help a company in the short run, but it is an opinion that depends on assumptions that can change.
Watch out
Common mistakes.
- Treating a strong buy rating as a guarantee of profit, when it is only an analyst's opinion at one moment in time.
- Comparing ratings from different firms as if they used identical definitions.
- Ignoring who employs the analyst, since firms that earn fees from a company may be more positive about it.
Questions
People also ask.
Is a strong buy the same as a buy?
No, a strong buy expresses higher conviction and usually a larger expected gain than a plain buy, though firms define the difference in their own way.
Why are there so many more buy ratings than sell ratings?
Analysts rely on good relationships with management and their firms often earn fees from the companies, so ratings tend to lean positive.
Should investors follow a strong buy rating?
It can be a useful starting point, but investors should read the reasoning and check the valuation themselves.
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