One of the most important skills a stock-picker has is the ability to screen for stocks using criteria that can reduce the stock universe to a reasonable size. With over 6,000 stocks listed in the United States, looking into even 5% of them would be overwhelming. By using company fundamentals to screen for stocks we can reduce the number of companies we have to look at while increasing the odds of finding good investments.
Screening stocks based on fundamentals is not the only way to find stocks but it is usually the best way. If we can devise a stock screen that on average would have in the past chosen stocks that beat the market, then we can beat the market even if our more detailed analysis adds no value.
MSN Money offers the best free stock screener, although it requires you to use Internet Explorer to use it. Yahoo Finance offers a good stock screener that can be used with any internet browser. I encourage you to play with both screeners to see which you like better. Each of them has many different criteria you can use to screen for stocks. The choices are quite overwhelming at first. I will detail some of the more important.
First, there are valuation ratios. These are the most important because these tell you how much you are paying for the company. For all of these ratios, lower numbers are better. The most common ratio is the P/E ratio, which tells you how much you are paying per dollar of earnings. This is useful, but do not use it by itself. My favorite valuation ratio is the P/CF ratio, which shows how much you pay for each dollar of cash flow from operations. Other common ratios include the P/B (Price / Book) ratio, which tells you how much you are paying for each dollar of book value (assets minus liabilities). Another valuation ratio that may be of use is the P/S (price / sales) ratio. This is particularly useful, along with the P/B ratio, when looking for companies that are experiencing losses. You can make good money by finding companies in this situation that are on the verge of a turnaround.
After valuation ratios, profitability and efficiency ratios are the most important criteria for stock screening. Higher numbers are better for all of the following ratios. Return on assets (ROA) along with return on equity (ROE) show how much profit a company makes for each dollar of assets or equity. Net margin and gross margin (also known as operating margin) detail how much profit (or operating income) a company makes for each dollar of sales. Besides the standard profitability measures listed above, I like to use certain measures of efficiency, such as inventory turnover (the number of times the company sells off its inventory each year) and asset turnover (sales / assets). Along with looking at absolute numbers for these ratios, it can be useful to screen for companies that are increasing their inventory turnover and asset turnover.
Debt is the last thing I usually screen for. It is generally good to avoid companies with excessive debt, because they are at risk of bankruptcy. The most common way to do this is to use the debt / equity ratio. This is a measure of how much of the funding from the company is from debt and how much is from stock. Companies with a debt / equity ratio above 1 are generally considered to have too much debt. Another useful ratio to use is the quick ratio. This is a measure of how much current assets (excluding inventory) a company has in relation to its current liabilities (those due in under one year). Numbers above 1 are good. The current ratio is a similar measure that includes inventory. Current ratios should be above 2.
There are many other criteria you can use when screening for stocks, but those above are the most important. Even just using these criteria, you can create many different screens: you can look for companies based on the values of the above criteria or you can look for companies with improvement in those criteria (such as improving profitability). I hope this article has given you some ideas for screening for stocks. Remember to always look at a company in more detail after it pops up on a stock screen.