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Screening is a process that permits investors to discover and distill useful
information from a larger set of information. The Internet provides many
screening tools that help you prospect stock issues. The goal of stock
screens is to point out which stocks are worth your research and analysis
time.
Some people believe that using a stock screen is like panning for gold. You
use your computer to screen (“pan”) for investment “nuggets” from a long list
of possibilities. The online investor sets the objectives of any single screen.
Different people get different results because no two people have exactly the
same selection criteria or investment philosophy.
Overall, the benefit of stock screens is that they enable you to generate your
own ideas — ideas that generate profits based on your investor savvy. Stockscreening
programs enable you to go beyond finding good stock investments
and assist you in finding the very best stocks.
To identify investment candidates, the stock screen uses your preset criteria,
such as growth (stocks that are expanding faster than the market or their
peers), value (stocks that have strong financial statements but are selling
at prices below their peers), or income (stocks that provide higher than
average dividends).
Depending upon the criteria you select, you may have to run several iterations
of the stock screen. For example, your first screen may result in several hundred
possibilities. Because you can’t investigate and analyze so many candidates,
you have to run a second screen of these results. This fine-tuning should
lead to a manageable list of investment candidates that you can research and
analyze — perhaps between 10 and 20 candidates. You can quickly pare down
this number by using common sense and your investor savvy.
When screening, identifying exactly what types of stocks you seek is important.
Consider writing down your investment objectives and the characteristics
of your ideal investment. Don’t forget to consider your performance
expectations and risk-tolerance level.
Choosing the criteria for your first stock screen
Typically, you build a stock screen by accessing an online stock-screening
tool and filling out an online form. I offer examples of the variables used in
these forms later in this article, in the section “Important ratios for screening
stocks.” The first stock screen that you develop may include quantifiable
variables that you believe are the most important — for example:
Earnings growth: The percentage of change between current earnings
and earnings for the last quarter or last year.
Recent earnings surprises: The difference between predicted and actual
earnings.
Price/earnings (P/E) ratio: The current price of the stock divided by the
earnings per share — that is, net income divided by the total number of
common shares outstanding. For example, value stocks have P/E ratios
below 10 or 12, and growth stocks have P/Es above 20.
Dividends: The annual cash dividend paid by the company.
Market capitalization: The number of outstanding shares multiplied by
the current stock price of those shares. Market capitalization is sometimes
abbreviated as cap. This value is a measurement of the company’s
size. Firms with high market capitalization are called large cap, and companies
with a low market capitalization are called small cap.
Fine-tuning your stock screen
After you select your initial screening criteria, you click Submit, Sort, or a
similar command. A list of stock candidates appears. Often, this list includes
several hundred stocks. This number is still too large to research, so you
should narrow this list by selecting more variables.
You may have some special knowledge about the industry you work in. You
may have used certain products over the years and can use your knowledge
to your advantage. However, keep in mind that a good product doesn’t necessarily
mean a good company. You may want to filter out companies that you
just don’t understand. You might also want to filter out companies about
which you lack information. Without at least some basic information, you
can’t perform a complete analysis.
Using your stock screen results
After you complete your second stock screen and sort the data, you should
have a list of 10 to 20 companies. Start a file for each firm and begin to gather
data for your analysis. At this point, you might discover that some companies
aren’t worth additional research — a finding that further reduces your short
list. For example, the company may have filed for bankruptcy, or it may be
targeted for federal investigation. Maybe the company recently paid a large
fine for shady dealings, or the executive management was recently indicted
for fraud, misconduct, or some other crime.
Important ratios for screening stocks
Every industry has its own language, and the financial industry is no exception.
In the following sections, I define the key terms that the finance industry
uses for stock-screening variables.
The following are definitions of the criteria most often used in screens. I define
these terms so that you can better understand what’s included in prebuilt
screens. When you get comfortable with using prebuilt screens, you can use
these definitions to set parameters to build your own customized screens.
Beta
Beta is the measurement of market risk. The beta is the relationship between
investment returns and market returns. Risk-free Treasury securities have a
beta of 0.0. If the beta is negative, the company is inversely correlated to the
market — that is, if the market goes up, the company’s stock tends to go
down. If a stock’s volatility is equal to the market, the beta is 1.0. In this case,
if the stock market increases 10 percent, the stock price increases 10 percent.
Betas greater than 1.0 indicate that the company is more volatile than the
market. For example, if the stock is 50 percent more volatile than the market,
the beta is 1.5.
Book value
Book value is the original cost, less depreciation of the company’s assets and
outstanding liabilities. (Depreciation is the means by which an asset’s value is
expensed over its useful life for federal income tax purposes.)
Cash flow to share price
The ratio of cash flow to share price is the company’s net income plus depreciation
(expenses not paid in cash) divided by the number of shares outstanding.
For companies that are building their infrastructures (such as cable
companies or new cellular companies) and therefore don’t yet have earnings,
this ratio may be a better measure of value than earnings per share (EPS).
Current ratio
Current ratio is current assets divided by current liabilities. A current ratio of
1.00 or greater means that the company can pay all current obligations without
using future earnings.
Debt to equity ratio
To determine the debt to equity ratio, divide the company’s total amount of
long-term debt by the total amount of equity. (Equity is defined as the residual
claim by stockholders of company assets, after creditors and preferred stockholders
have been paid.) This ratio measures the percentage of debt the company
is carrying. Many firms average a debt level of 50 percent. Debt to equity
ratios greater than 50 percent may indicate trouble. That is, if sales decline,
the firm may not be able to pay the interest payments due on its debt.
Dividend yield
Dividend yield is the amount of the dividend divided by the most current
stock price. You can use dividends as a valuation indicator by comparing
them to the company’s own historical dividend yield. If a stock is selling at a
historically low yield, it may be overvalued. Companies that don’t pay a dividend
have a dividend yield of zero.
Dividends
Dividends are a portion of a company’s net income paid to stockholders as a
return on their investment. The company’s board of directors can declare or
suspend dividends. A primary benefit of dividends is that once paid, they’re
cash that can be banked and can provide a return (in the form of bank interest)
when stocks are weak. A limitation of dividends is that they’re taxed as
ordinary income. For an individual investor in a high tax bracket, this can
increase their usual tax bill.
Earnings per share (EPS)
Earnings are one of the stock’s more important features. After all, the price
you pay for a stock is based on the future earnings of the company. The consistency
and growth of a company’s past earnings indicate the likelihood of
stock price appreciation and future dividends. Earnings per share is often
referred to as EPS.
Market capitalization
Market capitalization is the total value of the firm. It’s calculated by multiplying
the number of outstanding shares times the current stock price of those
shares. Market capitalization is sometimes called market value.
P/E ratio
You calculate the price-to-earnings ratio by dividing the price of the stock by
the current earnings per share. A low P/E ratio indicates that the company
may be undervalued. A high P/E ratio indicates that the company may be
overvalued.
Price-to-book value ratio
Price-to-book value ratio is tangible assets less liabilities, and the price-tobook
value is the current price of the stock divided by the book value. If the
company has old assets, this ratio may be high. If the company is a new startup
with fixed assets that haven’t been depreciated, this ratio may be very
low. Therefore, you need to compare this ratio to industry standards and
other information about the company.
Return on equity (ROE)
Return on equity (ROE) is usually equity earnings as a proportion of net
worth. You divide the most recent year’s net income by shareholders’
equity (shareholders’ equity is assets minus liabilities) to calculate ROE.
Shares outstanding
The term shares outstanding refers to the total number of shares for a company’s
stock. To determine the firm’s outstanding shares, you need the most
recent data. The shares outstanding can be calculated by taking issued shares
on the balance sheet and subtracting treasury stock. Treasury stock is stock
issued but not outstanding by virtue of being held (after it is repurchased) by
the firm.
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