In today's global economy, weeding through vast amounts
of information to arrive at an investment conclusion is very
difficult. But there are steps you can take to create a
screening process to help sift through the large universe of
ideas and arrive at a manageable number that merit further
investigation. Here, we'll take you through those steps.
Step 1: The Broadest View
Some investors start their search with an
industry or theme that has compelling drivers for growth but is
currently out of favor. As an example, prospects for growing
household formation led some investors to favor building stocks
after the real estate crash of the early 1990s. Others look for
industries that are strong but still have room to grow based on
their positive long-term fundamentals. With the aging baby
boomer population, healthcare has been such a theme in the
2000s. Choosing a theme can be a first step toward creating a
smaller universe of stocks.
Step 2: Company Statistics
Once a theme is established, whittling
down the potential universe of stocks is necessary. Many
investors have a particular company size they are comfortable
with. Market capitalization of the firm, calculated by
multiplying the number of shares outstanding by the current
stock price, is a common measure of company size. Generally,
firms are categorized as micro-, small-, mid- and
large-capitalization, depending on the outstanding value of
their stock. Most investors are familiar with the large-cap
companies that are household names, such as General Electric
(NYSE:GE), Proctor and Gamble (NYSE:PG) and Pfizer (NYSE:PFE).
However, some themes focus on more obscure segments of the
market where only smaller companies participate, such as ethanol
or modular rental companies.
After narrowing the potential list of companies by
market capitalization, investors may review company
characteristics, including growth prospects. If a company or
industry is in the early stages of the business or product life
cycle, investors generally expect very high growth in sales,
earnings, or other relevant numbers. More mature companies are
expected to display slower growth, but at a steadily rising
rate. Growth also plays a role in dividend payments. Younger or
high-growth companies usually reinvest free cash flows back into
the company, while more mature companies may choose to use cash
flow to pay above-average dividends.
Other components of a screen focus on a company's
financial position through financial ratios, such as liquidity
ratios, debt ratios and profitability ratios. Liquidity ratios
generally look at a company's cash and short-term asset position
relative to its short-term liabilities and its ability to meet
its short-term obligations, particularly working capital. Debt
ratios generally look at a company's ability to service its debt
obligations and the size of a company's debts relative to its
equity or assets. Finally, profitability ratios provide
information about the return on assets employed, dollars
invested, or equity held.
Another screen includes stock valuation parameters that
help investors determine whether a stock price is attractive
relative to the company's earnings, assets, book value, and
other characteristics. Common valuation multiples include
price-to-earnings (P/E), price-to-sales (P/S), price-to-book
(P/B) and enterprise value to earnings before interest, taxes,
depreciation and amortization (EV/EBITDA).
Step 3: Constructing the Screen
There are several professional software
packages for screening, and some brokerage firms and public
websites also offer much of this information. To construct a
screen according to the above criteria, investors first need to
determine investment goals, particularly time horizon, tax
implications and risk tolerance. Once goals are determined,
investors can choose the criteria parameters used in the screen.
(For more on this, read
| Example 1
A 22-year-old investor just landed his first job out
of college and wants to put some graduation gift money
into some stocks. He has a long time horizon, wishes to
minimize taxes, and has a high risk tolerance. He feels
comfortable with an early-stage company that offers high
growth potential over the long term, but also higher
risk than a more mature company. His screening criteria
focus should be the following:
- Early-stage industries
- High revenue growth
- Smaller market capitalization (less than
$1 billion)
- Ratios: early stage companies generally
have unattractive ratios as they seek capital and
spend more than they have to launch the business
- Valuation: generally only price-to-sales
is a possible measure as earnings are typically
negative
|
Example 2
A recently retired man with no dependents other than a
spouse and no long-term debt generally has a lower risk
tolerance and needs to ensure his savings will last
through the remainder of his life. This investor feels
more comfortable with mature companies with lower growth
potential. His screening criteria should focus on the
following:
- Mature industries
- Low- or no-growth companies
- Larger market capitalization
- Ratios: strong liquidity and low debt
ratios, high return ratios
- Valuation: generally any ratio fits, but
using P/E, P/B or EV/EBITDA are common; this
investor should seek low multiples and high dividend
yields
|
Step 4: Narrowing the Output
Even after the use of screens, many
companies may still fit your criteria. Narrowing the list
requires some further scrutiny about the particular companies,
such as one's comfort level with the industry, or personal or
social concerns. When the field is narrowed sufficiently, it is
time to perform deep analysis of the company using all publicly
available information, including Securities and Exchange
Commission (SEC) filings and company or investor websites.
Conclusion
While an abundance of information and
options can make investing overwhelming, understanding your
investment goals and constructing a screen based on those goals
will help you select stocks that meet your needs. However, it is
important to remember that these screening steps, while
narrowing down the list of potential investment candidates, are
no replacement for in-depth fundamental analysis.
