Screening for the Best Stocks

We're lucky to live in the time that we do. We have amazing conveniences our ancestors couldn't have dreamed of.

And when it comes to researching stocks, we no longer have to pore through thick directories of companies to study lots of numbers and make long lists. (Imagine what this used to be like -- there are thousands of publicly traded companies out there!) Now websites such as Yahoo! Finance calculate returns on equity, price-to-earnings ratios, and dividend yields, all without our having to lift a calculator.

But those websites can do more than calculate ratios. They can also run stock screens to help narrow our list of companies to research in the first place.

Narrowing the field
For example, let's say I want to find some undervalued stocks. I can go to Yahoo! Finance and use its basic stock screener to find S&P 500 companies with P/E ratios of less than, say, 20 -- because a relatively low P/E ratio suggests that a company may be undervalued.

Out of the 500 companies in the S&P 500, 295 meet that criterion. That's still a lot of companies to look at, so let's narrow it down further. I'll add net profit margins above 10% to the screen, and now it's down to 138 companies. Still, that's a lot to wade through.

Using Yahoo!'s more detailed screener, I'll add estimated earnings growth over the next five years of 10% or more. Now we're down to 75 companies -- a manageable list with which to begin further research.

With stock screeners, you can use whatever criteria are important to you to create a reasonable list of companies to research further. For example, here are some that piqued my interest from the screen I just detailed:

But getting a list of companies is only the first step.

I've got a list. Now what?
One of our primary tenets at The Motley Fool is that you shouldn't be investing in companies and industries you don't understand. So once your list is a manageable length, you'll probably be able to narrow it further by eliminating companies in industries you don't have a handle on.

Then you research. Compare key criteria such as P/E ratio or earnings growth against those of the industry as a whole and against other companies in the same industry. How does this company stack up? Look at a company's historical P/E ratios or earnings growth, and ask yourself how the current numbers compare.

If earnings are growing well, look more closely to see how they're being generated. Are they mainly from operations -- making and selling whatever the company makes and sells -- or has the company been selling off divisions? Are these earnings sustainable?

Investigate what else is going on in the company's story. Has the entire market slumped, or is the company facing some challenges? If it's the latter, are the challenges likely to be fleeting and surmountable, or might they ultimately sink the company?

But wait! There's more.
However helpful screens are, they're likely to leave out possibilities you'd be very interested in. Consider, for example, Wal-Mart (NYSE: WMT). It has a seemingly low net profit margin of less than 4%), but it's not exactly a laggard. What it lacks in profit margin, it makes up in volume. The stock has been stagnant for the past few years, but there are ample signs of life at the company, and it's still growing at an impressive clip for such a behemoth.

Your screen is only as good as the criteria you feed it, so give careful thought to what you choose. It's good to see a hefty profit margin, but if a company's sales are slipping or aren't substantial to begin with, that great margin may not result in absolute profits.

If the thought of researching dozens of companies is just too much, consider our Motley Fool Inside Value investing service. Lead analyst Philip Durell and his team screen the stock universe looking for "good companies that have had a bad quarter or two, are turning around after troubled times, or are moving toward the high points of their business cycles." Among other things, they look for excellent management, great assets, strong cash flow, and a competitive advantage.

If you want to do more research, you can take a free 30-day trial, during which time you'll have full access to all of our past issues and recommendations.

Longtime Fool contributor Selena Maranjian owns shares of Wal-Mart and 3M, which are both Motley Fool Inside Value recommendations. The Motley Fool is Fools writing for Fools.