How Should You Approach Analyst Upgrades and Downgrades?

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First off, what is an upgrade or downgrade?

Analysts put price targets on stocks. They say what they think the share price should be right now, purely based on the company’s valuation. That price target reflects a certain rate of return or loss relative to what the share price is actually trading at. That return or loss makes the stock a buy, hold or sell. So when an analyst upgrades a stock, he or she is moving his or her rating from 'hold to buy' or from 'sell to hold,' for example.

Let’s say an analyst has a $100 price target on company ‘X,’ which is trading in the market at $85 a share. In essence, the analyst is saying that the market is under appreciating the company’s earnings by about 17%. So you would assume the analyst would call this company a buy, right?

But analysts are industry experts. And let’s say company 'X' is in an industry in which the analyst expects the average stock to rise about 20% for the next year or so. All of a sudden, 17% doesn’t look as good. So an investor who agrees with the analyst is likely not going to buy too many shares of company ‘X’ and the analyst likely has a hold or sell rating on the stock.

But what if something changes? Company ‘X’ has cracked the code on making a competitive product that can enable the company to take market share from others for the next few years. So, the analyst raises his or her price target to $108 a share and the stock only trades up to $87. That implies a return of 24%. The analyst will likely upgrade company ‘X’ to 'buy.'

If you agree with the analyst’s perspective you probably want to buy ‘X.’

But beware. Sometimes an upgrade occurs without any fundamentals in the company changing -- and as an investor, you need to watch more than just analyst’s upgrades or downgrades.

The point? You the investor need to decide if a stock is trading lower for a real reason or if it's a good opportunity to buy what could be an undervalued stock.

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