The equity analysts’ job is to:
1. Forecast the future of the business and its business lines.
2. Assess competitive threats and emerging risks.
3. Measure the riskiness so that it can be quantified in the discount rate (how aggressive earnings in the future are discounted at present.)
4. Come up with a value for the company.
Upgrades and Downgrades vs. Price Targets
The most actionable part of an analyst rating is the price target. You see, the headlines often read “X company is downgraded by X firm.”
Depending on the name of the firm, this has varying effects on the stock price. A well known firm that manages substantial amounts of capital is going to move the markets more than another. Of course, this is all relative. Even smaller firms like Feltl & Co. (I hadn’t heard of them, either) sent Metropolitan Health Networks down 10-15% on a downgrade from strong buy to buy in August.
Downgrades or upgrades are related entirely to the price target. For instance, if an analyst believes a stock is worth $12 per share, then he’s not going to rate it a buy at $11 – it’d be more like a hold. Likewise, if an analyst thinks a company is worth $12 and trading for $6, that’s going to be a strong buy.
So, whereas the market moves based on upgrades and downgrades, the really important part is whether or not you’re buying more company than you should be able to buy. If a company with an intrinsic value of $12 is selling for $6, you’re getting more for your money. Remember, securities analysis is all about determining whether or not a company is a good value based on the whole market. A cheap stock isn’t cheap if the whole stock market is cheap; nor is a stock expensive (well…) if the whole stock market is expensive.
Should you listen to equity analysts?
Whether or not you should listen to analysts is up for debate. Personally, I try not to, mostly because I don’t want their analysis influencing mine.
I think what we all have to remember is that analysts are paid to value businesses. They are not paid to value businesses they want to invest in. So, suppose an analyst would never invest in…say, Intel because he or she isn’t all that confident in the future of technology or the management, or whatever it is. That analyst still has to give a value to the company.
If analysts were to give valuations only to companies they really liked, I think their analyses would be far more meaningful. I’d be willing to bet that analyst’s favorite picks of their watch group significantly outperform their least favorite. The problem is that neither you nor I have any way of knowing which companies they really believe in and which they don’t really like. Or which analyses they are least confident in. Fact is that any stockpicker knows when they find that one easy to value, easy to understand business. And they know how different it “feels” from a company that is hard to analyze.
You guys know I hate investing in companies in industries that are in constant flux. I avoid them like the plague with my own money. But if I were an analyst, I wouldn’t have a choice but to analyze the companies that my employer tells me to analyze. And you can’t exactly publish a report that says “hey, I don’t know how to analyze this” because no one gets paid for doing nothing. So realize that just because an analyst rates a company as a buy that doesn’t mean they’d put their own money into it.
Anyway, that’s just the lowdown on analyst upgrades and downgrades.