What Is a Covered Stock (Coverage)?
A covered stock refers to a public company’s shares for which one or more sell-side equity analysts publish research reports and investment recommendations for their clients. Upon commencement of coverage, an analyst will publish an “initiating coverage” report on the stock and subsequently issue research updates, often after quarterly and annual earnings or other material news. If anything material has changed, the covered stock may get a new analyst rating.
- A covered stock is followed by professional research analysts who publish fundamental research analysis and valuation metrics for that stock.
- A covered stock will receive a rating from an analyst, such as “buy,” “sell,” or “hold.”
- Critics have argued that so-called “sell-side” analysts have an incentive to issue more favorable ratings on the stocks that they cover, and shy away from issuing “sell” recommendations.
How a Covered Stock Works
Many brokerage firms provide proprietary research reports to their institutional clients as well as important retail clients (e.g. high net worth). The purposes of these reports are to support the investment decisions of clients and to generate trading commissions for the broker-dealers.
A sell-side analyst conducts thorough research on a company—its business model, competitive advantages, risks, management quality, financial performance, etc. The analyst then puts together a financial model that projects future earnings based on a set of assumptions.
The number of analysts covering a stock can vary widely. While blue chips or other well-known companies may be covered by several analysts, small companies may only be covered by one or two analysts. A company that is taken public by an investment bank will invariably have its stock covered by the brokerage arm of the investment bank to support trading of its equity in the markets and build an investor base for the shares.
Alternative terms like “outperform,” “market perform,” and “underperform” convey similar sentiments as “buy,” “hold,” and “sell,” respectively.
Investors may appreciate the work of a sell-side analyst to bring forth facts and data pertinent to a company, but they often take it with a grain of salt or ignore favorable recommendations altogether. It is rare for an analyst to attach a “sell,” “avoid,” or “underperform” rating on a stock. Most recommendations are “hold” or “buy,” or something analogous to these ratings.
The reason is that an analyst needs access to the management of the company to perform their work. The analyst must stay in the good graces of management to maintain the flow of important information so that research reports can be written and sent to clients.
Without the benefit of management access, the usefulness of an analyst to its brokerage clients will decline. Therefore, the analyst feels pressure to slap on favorable stock recommendations, whether or not they truly believe them.
However, an analyst can drop coverage of a particular stock for various reasons. This may include switching firms or if it becomes too difficult to predict the company’s future earnings.
Covered Stock vs. Price Target
In general, an analyst will calculate a specific price target for covered stocks. An analyst derives this number using key drivers, such as sales. In a discounted cash flow (DCF) model, the analyst will start by projecting a company’s future free cash flows. From there, they discount them using a required annual rate to arrive at a present value estimate.
In turn, this present value estimate becomes the price target. If the value that the analyst arrives at through DCF analysis is higher than the company’s current share price, the security is underpriced and will potentially receive a “buy” rating. If the present value estimate is lower than the market price, the analyst could issue a “sell” rating and mark the security as overpriced.