The market is full of analyst recommendations on stocks. Some good, some bad and some just okay.
So how do brokers come up with these recommendations and what should you consider before acting on these recommendations?
Most brokers will have a research area where the heart of their job is to come up with an 'intrinsic value' or 'real value' for the company that is listed on the sharemarket.
If the stock is trading below that intrinsic value, it is considered a buy. If it is trading above, it is considered a sell.
So what do analysts take into account when determining an intrinsic value?
The first thing to consider is that in trying to determine what a stock is worth, analysts will make a guess of what they think future earnings for the company will be.
The better the analyst understands the company, the more credibility their rating is given in the market place.
The problem with this is that the guess or estimate that the analyst makes is based on the current situation. We really cannot know what the future actually holds and that is why these recommendations change as new information is revealed.
So you need to remember to take these recommendations with a grain of salt.
Consider how well the analyst understands the company and keep track of any new developments which may change recommendations.
In figuring out an intrinsic value, an interest rate is used to discount future cash flows for the opportunity cost of time.
That means as interest rates go up, stock valuations in general fall (if all other things stay the same).
Hence, falling interest rates are generally a positive for the sharemarket and rising rates are a negative.
There are other many ways to find out what to invest in.
Some investors prefer not to use forecasts at all, saying that no-one has a crystal ball. These investors instead usually turn to the history of the company.
By reading the past, they hope to invest in companies that have had a good track record and will probably continue to perform well in the future.
In fact, experienced readers of financial statements and numbers will often be able to guess what the company is planning next.
If the company has low levels of gearing and high return on capital with lots of cash then it could be time for the company to acquire new companies or become a takeover target themselves.
Unfortunately, the market doesn't always recognise good quality companies or intrinsic value. That's where technical analysis or charting comes in handy as a timing tool.
Most analysts don't use technical analysis, but for the savvy investor, timing can make a big difference to your returns in a portfolio.
Overall, I like to look at analyst recommendations and also keep an eye out for new information that is likely to impact the stock.
A stock's history is always useful to get a gauge on how well the business is being managed.
And I use technical analysis to time my way into investments.
No-one has a crystal ball, but by evaluating the business, the business cycle and interest in the company, it's about as close as you can get to looking into the future.
Follow my sharemarket updates on Twitter: http://twitter.com/belldirect
Happy investing!
Julia Lee Equities Analyst Bell Direct
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