Stocks are categorised as ‘buy’, ‘hold’ or ‘sell’ depending on the professional opinions of analysts at any given point in time. As a trader, you will want to know where the stock is currently at, so that you can make the most educated decisions.

At any given time, you are tasked with making quick decisions regarding your portfolio of stocks. Delays in action can result in your losing out on profitable trading opportunities or, worse yet, loss of your entire investment. Learning how to read the market is a skill that takes years to master, and even then it’s not a perfect science.

Before you delve into the inner mechanics of what comprises a stock’s value, it is important to point out that making trading decisions on the fly often precludes your accessing pertinent information from the company. Consider that research reports and management evaluations are not always available or accessible to everyday traders.

A good rule of thumb is to access earnings reports from the last two cycles. This is your point of departure.

Factors that determine the earnings potential of stocks

If sales growth is improving (10% for small companies and 3% for large companies) there is a case to be made for buying a particular stock. Quarter-on-quarter growth is also important in this regard. With improving margins one can expect a positive stock performance in the future.

A lesser-known harbinger of future earnings comes in the form of company guidance. This is essentially the company’s own forecast of its future performance. If the guidance is positive, the stock will likely be a buy, whereas if the guidance is negative this will cause the stock to be a hold or a sell. Likewise, long-term positive guidance will cause a stock to be a hold in the short term but a definite buy in the long term.

Investors tend to take the strategic approach to investments in stocks, while traders tend towards the short-term perspective. A trader may sell a stock that is expected to generate profits only in the long term, while an investor may look beyond the present and see viability in the strategic approach.

The value of stocks can also be ascertained by the company’s approach to repurchasing stock. If the company opts to buy its own stock to revalue itself, this should be viewed positively and move the stock from a sell or a hold to a buy. A caveat is in order however: management may decide to buy stocks to reduce the public exposure of the company. This may have the desired effect of making the company look good to investors and analysts.

Another important barometer of where a stock is on the buy-hold-sell chain is the number of shares in issue. If the share count is continually increasing, this should be viewed negatively. The reasoning is simple: companies with too many shares on the market are dividing up their EPS among too many shareholders. This has the effect of diluting shareholder value. This decreases profitability and undermines your investment in the stock. A company that adopts such practices will likely move from a buy to a hold, a buy to a sell, or a hold to a sell.

Downgrading from a hold to a sell

If an analyst advises a trader not to hold a stock any longer and to sell that stock, the analyst is going short on the stock. In other words, there is bearish sentiment around the stock and it is no longer considered to be a viable investment opportunity in the short, medium or long term.

Of course it’s perfectly plausible that an analyst can advise that a stock be downgraded from a hold to a sell and then upgraded from a sell to a buy, if market forces demand. The decision to recommend a downgrade of a stock from a hold to sell is based on complex analytics.

Analysts make their living out of informing traders and investors what to buy, hold or sell at any given time. It’s important to remember that they make money regardless of whether their assessments are accurate. They charge fees and take commissions on trades that are executed. However, the long-term success of an analyst is dependent on that professional’s ability to accurately forecast price movements more often than not.

Downgrades in stocks are changes in the ratings of these securities. Once analysts believe that the future potential of a stock is limited, or weakened, the negative change will come into play. The reasons why a stock may get downgraded are varied and include poor future projections for the company and perhaps even the industry as a whole. Information gleaned from the company’s financial statements plays an active part in any ratings changes that are made.

Brett Chatz
Intertrader

Published: 12 June 2015

You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.