How to Find a Great Tech Stock

One of the questions I get most often as an analyst is "How do you find the stocks you recommend?" There are actually a number of ways to go about idea generation, but one of the best and most replicable for investors at home is screening. This means asking a computer to look for companies that fit several pre-determined and desirable criteria.

The difficult part of screening, of course, is knowing what to ask the computer to look for. So to help you out, I thought I'd share with you today one of the screens I'm using to identify promising tech stocks for my portfolio. There's a growing consensus among investors that this sector is cheap right now, and I know that I am underexposed there, which makes it a good time to buy some tech exposure.

Step 1: Identify a tech stock
The first thing one needs to do when looking for a stock in a specific industry is tell the screener to look only at that industry.

According to my screen, there are 875 companies trading on the major U.S. exchanges that are considered part of the "Information Technology" industry. That's too many to be helpful, which means we need additional criteria.

Step 2: Identify a durable business
One of the reasons I'm underexposed to the tech sector is because the rate of change in the industry is so fast, and I've found it difficult to figure out which companies are here to stay and which are prime for disruption. Thus, one of the things I'm looking for in a tech sector stock is a history of free cash flow. This indicates that the company is succeeding in its space without having to spend too much to keep up with the rate of change.

According to my screen, there are584 tech companies who have generated free cash flow in each of the past five years. That's also too many to be helpful, which means we need additional criteria.

Step 3: Get some growth
One of the most attractive aspects of the tech sector is that it's fast-growing. Optimally, I'd like a company that's riding this wave and that has posted better than 10% sales growth annually over the past three years.

According to my screen, 169 tech companies are achieving this rate of growth. That's still too many to be helpful, which means we need additional criteria.

Step 4: Identify a good value
Although the tech sector is notoriously expensive, one of the reasons I'm fishing here is because I've read that tech stocks are cheap today. While there are many ways to get after valuation, helpful thumbnails such as price-to-earnings and price-to-book multiples, one quick multiple I often use is enterprise value-to-EBITDA, which takes into account the state of a company's balance sheet and omits charges that are not core to operations. Generally speaking, anything below 7 here gets my attention.

There are 31 tech stocks that meet the aforementioned requirements and are trading today for less than 7 times EBITDA, which is a manageable number to look over.

Our candidates
After glancing at each of the 31 candidates, here are seven that caught my attention:

Data from Capital IQ, a division of Standard & Poor's.

Now, a few of these stocks, such as Research In Motion and Western Digital, look like value traps because of declining demand for their core products. Shanda, however, gets my attention. It's a fast-growing company in the fast-growing Chinese gaming market, it's received the stamp of approval from our tech-oriented Motley Fool Rule Breakers service, and frankly, despite fears that the Chinese government might regulate its gaming industry, that multiple looks attractive.

But remember: Screening is just the start of the research process. Savvy investors still need to look deeper at the numbers and investigate criteria one can't screen for, such as the market opportunity going forward and risks such as Shanda's potential regulatory issue.

That said, Shanda is a name I'll be investigating further as I seek greater tech exposure for my portfolio. If you're interested in starting to use screens yourself, click here to check out our free Motley Fool stock screener.

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