Understanding Analyst Ratings

In order to reach an opinion and communicate the value and volatility of a covered security, analysts research public financial statements, listen in on conference calls and talk to managers and the customers of a company, typically in an attempt to capture the findings for a research report. Ultimately, through all this investigation into the company's performance the analyst decides whether their stock is a "buy," sell" or hold." The question remains, however, is whether or not these recommendations are worth their salt?

The analyst ratings scale is a tad trickier than the traditional classifications of "buy, hold and sell." The various nuances, detailed in the following chart, include multiple terms for each of the ratings (sell is also known as strong sell, buy can be labeled as strong buy), as well as a couple of new terms: underperform and outperform. To top it off, not every firm adheres to the same ratings schema: an "outperform" for one firm may be a "buy" for another and a "sell" for one may be a "market perform" for another. Thus, when using ratings, it is advisable to review the issuing firm's rating scale, in order to understand the meaning behind the term.

For now, let us dissect the traditional ratings of "sell," "underperform," "hold," "outperform" and "buy," and assume that each firm, no matter how wacky the system, can map back to these. -

- Also known as strong buy and "on the recommended list." Needless to say, buy is a recommendation to purchase a specific security.

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- Also known as strong sell, it's a recommendation to sell a security or to liquidate an asset.

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- In general terms, a company with a hold recommendation is expected to perform at the same pace as comparable companies or in-line with the market.

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- A recommendation that means a stock is expected to do slightly worse than the market return. Underperform can also be lumped in with "moderate sell," "weak hold" and "under-weight."

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- Also known as "moderate buy," "accumulate" and "over-weight." Outperform is an analyst recommendation meaning a stock is expected to do slightly better than the market return.

Should an investor react accordingly to new analyst's recommendations and adjust a position based on the analyst's rating alone? Of course not. The research report and subsequent rating should be used to complement individual homework and strategy. If you are investing like Buffett, the report can assist in finding the company with the durable competitive advantage, and if Peter Lynch is your hero, you might find a low P/E ratio, share buyback or future earnings growth in the depths of the report.

In order to truly understand analyst ratings, it is imperative to gauge the accuracy. Below are three crucial moments in the lives of three well-known companies and the analyst ratings before the impressive lift-off, or dismal implosion, to see if the analysts got it right.

Coke is the world's largest nonalcoholic beverage company. Recently, the company reported strong global growth of 5%, net revenue growth of 6% and expectation-meeting EPS of 89 cents in its 2012 First quarter report.

Starting on July of 2010, Coke goes on a bubbling frenzy, rising from $50.05 to $65.77 on Dec. 31, 2010, a 31 % increase, reaching a new five-year high.

On Mar. 4, 2010, UBS upgraded its recommendation for Coke from a neutral to a buy. Conclusion: Score one for the analyst!

This company keeps the world caffeinated through a global chain of more than 17,000 company-owned and licensed stores. Starbucks recently reported an 18% increase in earnings per share to 40 cents, compared to 32 cents last year, beating analysts' expectations of 39 cents a share.

From Oct. 31, 2006, to Nov. 30, 2008, Starbucks plummets from $38.35 to $8.93 - a 77% drop. This double shot of drop can be partially blamed on recessionary pressures, but the company was also suffering from whole-roasted over expansion.

A slew of analysts' recommendations came out that fall and winter from Friedman Billings, UBS and Robert W. Baird. Both Friedman and Baird initiated coverage with a rating of "outperform" and only UBS downgraded the stock from "buy" to "neutral" on Oct. 10, 2006, but two months later they upgraded to a "buy." Conclusion: Missed the mark.

Apple designs consumer electronic devices, including PCs (Mac), tablets (iPad), phones (iPhone) and portable music players (iPod). Recently, the company reported a net profit increase of 94% and quarterly revenue of $39.2 billion in its second quarter report.

Starting on Dec. 9, 1998, Apple stock started climbing from a low of $7.91 to a then all-time high of $33.95 on Mar. 31, 2000.

During the spring to fall of 1998, two firms, Bear Stearns and JP Morgan, upgraded their recommendations to "buys," Robert Cohen downgraded to a "neutral" and three others initiated coverage with two "holds," a "buy" and a "neutral." For those keeping score at home, that's: three buys, two holds and two neutrals. The best penny stocks sent to your inbox! Conclusion: The tie goes to the runner or in this case, the analysts. Although not all jumped on the "buy" bandwagon, no "sells" bubbled up and overall, the ratings skewed to the buy side. Winner: Analysts!

Analysts' recommendations are the fountainhead of equity research reports and should be used in tangent with proprietary research and investment methodologies in order to make investment decisions. Additionally, "buy, hold and sell" recommendation meanings are not as transparent as they first seem; a plethora of terms and variance in meanings exist behind the curtain and serve to muddy the waters. It is thus important to understand a firm's entire scale when assimilating ratings.