Ratings of stocks are ubiquitous. You will find the following labels Buy, Hold, or Strong Sell all over the platforms and reports.
Although these labels may appear to come in handy, there is more than meets the eye. A rating in itself is not much unless you know how it was made. To retail investors, the process in a rating system is of importance rather than the rating score.
Examples of such models as https://finbotica.com/stock-ratings-methodology/ which demonstrates how systematic constructions can bring various factors to bear in order to come up with consistent results. Being educated on what is in that process will make you use ratings in a prudent manner rather than blindly.
Why methodology matters more than the label?
Even a mere rating may conceal pertinent information. Two systems can both give a stock a Buy rating but make their judgments based on vastly different information.
One may emphasise on short term momentum, whereas another will emphasise on long term value. In the absence of transparency, the investors cannot determine whether the rating is in line with their objectives.
A quality system of stock rating has well-articulated inputs, scoring criteria, and weighting. When it is a visible method you will be able to review the conclusions to determine whether it can make sense to your strategy.
Value: Is the stock reasonably priced?
One of the aspects of most rating systems is value. It examines the appearance of a stock as either costly or appealing based on earnings, income or property. Some of the common measures are price to earnings ratios, price to sales and other valuation measures.
To the retail investors, value indicators would assist in answering a fundamental question that is whether you are paying high in anticipation of growth.
An effective rating system is not based on a single measure. It juxtaposes various measures to prevent false indications. One company can appear cheap on one ratio and expensive on another. Balanced models explain this sophisticism.
Earnings strength and growth
The focus of long-term stock performance is on earnings. The quality and consistency of earnings is assessed by a reliable rating system. This is in terms of increase in revenue and profit margin and stability in results over a period of time.
The retail investors have the advantage of ratings that look at trends rather than a quarter of data. Unforeseen earnings surges might not last long.
An intelligent framework revises trends and compares them to those in the industry. This helps to minimize the chances of overreacting to short term changes.
Momentum: What is the trend saying?
Momentum is used to determine how a stock has been performing in the recent past. This involves price change during a period of several weeks or months and volume trends of the trade.
Whereas value is concerned with fundamentals, momentum is concerned with investor behaviour and market sentiment.
Momentum is disregarded by many investors, but it is a strong force in the direction of prices. A plausible rating system does not separate momentum and fundamentals but rather integrates them. Good earnings and favourable momentum might be far more effective than either of these.
Analyst sentiment and external views
Research, earnings estimates and rating changes are published by professional analysts. These perceptions affect the perception of the market. A standardized rating system can incorporate analyst revisions, upgrades or downgrades in its scoring system.
This is not to say that retail investors should blindly follow the opinions of the analysts. Nevertheless, monitoring the development of the expectations can be a valuable choice. When various analysts increase earnings forecasts, it can indicate a better underlying.
An excellent system of rating takes this information into consideration without making it to dominate the total point.
Risk factors and weighting
Weighting of various components is another important component. Does the model lay equal emphasis on the value, earnings and momentum or does it lay emphasis on one, at the expense of the other? The weighting defines the sensitivity of the final rating to certain changes.
Dependable systems reveal their organization. Transparency builds trust. Investors are able to understand the rationale behind the improvement or fall of the rating of the stock. This renders the rating operational as opposed to mystical.
Using ratings wisely
Research should be guided by stock ratings and not substituted. You have context when you see the way the score was arrived at.
You have the option to determine whether the priorities of the system are in line with your style of investment, whether you are focused on growth, value or balanced exposure.
An effective stock rating system uses several points of data, is transparent in its approach and continuously updated.
To the retail investors in need of practical advice, it is the framework that underlies the rating, which makes a plain label a tool of meaningful decision.
