Why do stock recommendations move share prices?

Among the biggest movers in a stock index on any given day, you’ll find stocks that have moved because an analyst at a large investment bank or brokerage has raised or lowered their ratings or price targets for a stock.

Ratings and price targets are obviously important drivers for share prices, but how are they derived and just why should investors care so much?

Why do banks and brokerages have stock ratings and target prices?

The banks and brokerages provide a range of services centered around shares, like stock broking for example. Deep analysis of the shares they cover and where the stock prices may be headed provides an extra service to their clients and an extra reason for signing up with that particular bank or brokerage.

How are they derived?

The analysts use numerous models to calculate stock valuations and work out whether the shares are undervalued, over-valued or fairly valued. They’ll also undertake fundamental analysis of the company, its sector and its prospects and add that into the equation.

Different analysts can use different models, and that can mean different conclusions for the same stock.

Why isn’t the terminology the same across banks and brokerages?

It can be confusing. One firm has Buy, Outperform, Neutral, and Underperform ratings for stocks. Those equate with Strong Buy, Buy, Hold and Sell at another firm. One has a target price for the stock derived using one valuation method, the other uses a different method to come up with its valuation.

Essentially, every firm has its own system, and an investor needs to understand that system before they use a rating to inform their own trading decisions.

Are ratings freely available to everyone?

The simple answer is no. Investment banks, brokerages and research houses produce research for their employers and clients. A large number will never send it out anywhere else. Smaller houses may make it available to financial journalists, while others may make certain research available on request. Their clients will always get it first.

You will see broker ratings and target price changes reported in various publications, as well as on data terminals. Those have either been provided by the originator, or financial journalists have used their skills and sources to get the information from the markets.

Can I trust the ratings?

Certainly more than previously. Regulators have tightened mandatory and voluntary rules governing research, and analysts at the large banks and brokerages are expected to be separated from those conducting dealings in stocks and shares. Analyst compensation is also supposed to be unrelated to any fees their employer earns from transactions related to the companies the analysts may be covering.

Rules have also been put in place to ensure a certain level of independence between analysts and the companies they cover, and to ensure that valuation methods are honest and appropriate.

Investors should still always look at the small print which should set out the relationship between the firm providing the research and the stock the analysts are writing about. Other analysts should provide reasonable disclosure, like whether they’re invested in a stock or asset they’re writing about themselves.

Why do ratings prove wrong?

Markets and events are unpredictable by nature. No model or valuation method can take into account future events that are unpredictable. That’s why it sometimes seems that analysts are reactive and behind the curve.

When a company issues a profit warning, there can sometimes be a slew of analyst downgrades in the following days. That’s because the analysts need to re-value and re-model using the new information that was contained within the company’s statement.

Most analysts will detail the key risks to their analysis at any given time, but even then there are a myriad of unknowns that could affect a company and its stock.

So how can the ratings benefit me?

The ratings have been derived using in-depth research and recognised valuation models by analysts who have trained to be able to conduct this. They can be good indicators in a market that can be driven by so many factors, from news, to sentiment to technical analysis.

However, investors should use ratings as part of their investment-making decisions, not base them purely on ratings changes.

Each rating change needs to be put into context: what do the analysts’ peers think? Have the most recent ratings changes all been upgrades or downgrades or is the picture more mixed? Why is it mixed? Are the analysts giving fundamental factors more or less weight in their analysis? Have the valuations and target prices been derived using different models?

Several publications rate analysts based on the success of their research outcomes, although rankings such as these seem to be becoming less readily available.

Investors should also still pay attention to where the research is coming from, and read the small print to ensure that it is as independent as it can be. Is it coming from a buy-side analyst who works for a mutual fund and sells their research for a fee? Or from a sell-side analyst. In which case, what’s the relationship between the analysts’ firm and the company being covered.

Be particularly wary around an initial public offering. Broad coverage of a stock doesn’t normally happen until after the listing, and so analysis of a stock is often limited to the firms that may be conducting the IPO transaction. Always do your own due diligence around an IPO, read wider reviews in the press, and listen carefully to what the company heading to market and its executives are saying and promising.

Beware the terminology. As described above, different firms use different ratings systems, and a Buy rating may not mean that an investor should immediately go and buy the stock. It needs putting in context.

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