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From Financials to Valuation, These Are the Levers Behind Every Good Stock Screen

By Motley Fool Staff – Apr 30, 2018 at 9:16PM

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Understanding the filters at your disposal will make your screening results much more attractive.

The promise of stock screens -- the ability to winnow down thousands of stocks to a few potential winners -- is often dimmed by the sheer confusion created by the innumerable filters available to an investor.

In this segment from Industry Focus, the cast categorizes the major metrics used to screen companies and explains how a metrics-based framework for running screens will sharpen your chances of finding companies that meet your investing needs.

A transcript follows the video. For the full episode, click here.

This video was recorded on April 24, 2018.

Vincent Shen: We have a basic framework for categorizing the various metrics -- and there are many of them -- that an investor can employ when they're doing a screen.

We have these broken up into four primary groups. Those are market and technical-based metrics, metrics from the financial statements, operational and other ratios, and valuation-based metrics. We're going to hit these one by one with a quick rundown of each category, and then how listeners can think about them.

For market and technical-based metrics, what does this include, Asit, and how do you generally approach this category?

Asit Sharma: These are the very broad first ideas that come to an investor when he or she sits down. I mentioned market capitalization. That's a market type of indicator. Another could be float of shares that are out there. So if you happen to be a more sophisticated investor who likes to short stocks, that's one of the first things that you want to know.

Technical-related, we don't want to go too deep in this podcast on technical ways of looking at a stock. We tend to be more focused on what's called the fundamental side, but some really important ones are moving averages. If you want to know how a company is doing relative to its own performance and its own stock chart universe, you would look at its moving average, either a 30-day, 50-day, 100-day or 200-day moving average. If the stock is above the moving average of so many previous trading sessions, then we tend to say that it's performing well in the market. And if it's taken a sudden dip below the average of many previous trading sessions, that's a reason to look at, what is the news coverage that's relevant to this stock? Maybe there's something that you need to be aware of. So that's one technical measure that I would definitely advise listeners to become familiar with.

As to some more sophisticated ones, the shorter your time frame, the more you can peel this onion. You can look at stochastic measures and all kinds of fancy things, but those become more the realm of traders than true long-term investors. So that's the first set, is market and technical. Should I jump into the next section?

Shen: I'll just add that this category is going to include some of the high-level things you mentioned, market cap, but also things like dividend yield, trading volume, the short interest that you mentioned, and stock performance over various time frames. And I mention that last one, because most commonly, those market-based metrics are what help me narrow down my screen results, especially for company size and recent stock performance. For stocks that declined, for example, I put on my bargain hunter hat and I think to myself, why is the company down over my established time frame. Is there an opportunity here from the market, for example, overreacting to short-term headwinds? Or maybe the company has been on my watch list previously, and now that the price point is more digestible -- of course, assuming the company's fundamentals haven't changed significantly -- is this a good time to basically get a bargain?

On the flip side, and this is how we came upon Estée Lauder, which came up on the show and was the focus of Industry Focus about two weeks ago, for stocks that have really outperformed, why is the market essentially so excited about that stock? Are there advantages or tailwinds that are sustainable going forward? So kind of a high-level approach to that process.

We'll move on now to the financial statements. What is the need-to-know for this category, Asit?

Sharma: This is also very high-level, and you don't have to be an expert in accounting or finance to use these basic screens, but they pertain to the three major financial statements -- income statement, then you have the balance sheet, and statement of cash flows.

Income statement, really basic, you want to look at profit margin, maybe operating margin. These are net margins that tell you the company is making money -- for every sales dollar, what's it taking home. If you set a screen to profit margin above, say 10%, that means that that company at the end of the year is generating at least 10% profit on every sales dollar. And the better screens out there will let you do that, such a simple screen. So income statement, I would stick to those.

Operating margin is another one. That tends to be focused on how a company does operationally before it accounts for its debt, interest expense on that debt, forward accounts for taxes. To give you an example in, let's say Yahoo Finance, which we'll talk about, they give you a way to look at the operating income of a company and that margin, which is always a little higher than the profit margin. So,I would stick with a couple of those in income statement.

Revenue growth is one more that is very popular. Vince just talked about watching Estée Lauder's stock chart, and he found that by screening for companies which had moved up their stock chart very persuasively in a one-year period. You can do the same for revenue. The company suddenly has a jump in its revenue or earnings -- earnings is important as well -- then, that's a reason, maybe, to investigate further.

As for the balance sheet, you want to look at cash on the balance sheet. You can screen for how much cash a company has. And look at that vs. what its current liabilities are, such as accounts payable. You can also look at total assets vs. total liabilities, just to get a feel for if the company is solvent. You don't want the equation to be flipped upside down. For example, let's say you run a screen and see that a company's liabilities are well in excess of its assets. There's actually a place to make up for that difference in a company's financials -- that's the equity portion of the financial statements. But that's maybe a sign of danger. It also could be the case that the company which just showed that flipped equation happens to be investing very heavily in capital equipment, for one reason. It depends on the industry.

But balance sheet, you're basically looking to get a feel for the company's resources vs. its obligations. Again, the major services present very easy-to-understand screens for this. You can look at total assets vs. liabilities, you can look at total assets vs. long-term debt, and just get a very basic sense of how that company stands with its resources.

The third is the statement of cash flows. I tend to zero in first on operating cash flow to know, how much cash is a company generating from its operations? You can screen for operating cash flow. You can also screen for free cash flow, which is simply operating cash flow less what a company has spent on its physical assets, its equipment, maybe acquisitions. Free cash flow is a very popular measure with investors, because it gives you a sense of how strong a company is. After it's paid for all of its fixed overhead, how much cash does it have left over then to buy equipment? The next remainder after that can be used for debt service, can be used to maybe pay a dividend to shareholders.

So those are the three basic financial statements, and a few of the screens that you might run for each of those.

Shen: Perfect. Keep in mind, things like revenue growth, earnings growth, cash flows, even things like R&D spending, with the financial statement metrics, there's tons and tons of options here. It gives you a lot of flexibility, depending on what you're looking for, what criteria you want to set, I think a lot of those will fall into this specific category.

But I think it's the next category, with operational metrics and ratios, where the screening really shines for investors, in terms of being able to hone in on their desired traits in a company. This is something I use a lot to filter down those results. Honestly, we could spend a whole week discussing all the various financial ratios that are out there themselves. But for the purposes of this discussion, we'll just focus on the idea of having a tool belt with various ratios that prioritize what you want to see in a company. So for example, retailers in our space, that might mean fast inventory turnover relative to its peers, or robust debt coverage, which they might combine to give the company financial flexibility, to expand its store base, maybe make an acquisition. They also indicate that the business can accurately estimate its demand for its products and adjust to consumer trends as necessary.

But with operational metrics and ratios, how do you approach this category, Asit?

Sharma: The same way that you do, Vince. I love the example you gave. After I've done the basic screen filters, put those into the software that we went through, I might look at something like inventory turnover. I want to give listeners a really quick example. I recently wrote about TJX Companies, the parent company of T.J.Maxx, HomeGoods, Marshalls. And I'm fascinated by their position as this off-price retailer. Just to see -- I didn't put this into a stock screen, but it could have very well turned up if I had made a query -- but I looked at its inventory turnover. This company turns its inventory over eight times every year. That is super fast. And that is a sign of a very strong retailer, and it also really supplements their strategy of offering the discount merchandise that other retailers and manufacturers don't want anymore that they need to move, they sell it to T.J.Maxx and T.J.Maxx sells it to the price-conscious shoppers, of which it has legions of fans.

But once you do these first basic screens, you can add something like inventory turnover. Let's look at just one more that Vince mentioned, which I like very much -- it's debt coverage, to see, how many times can a company cover its interest expense in a year? You might just pull one or two debt coverage service ratios off of a screen, just to see, does this company have the ability to pay its debt obligations. Everything else looks good. So this is maybe a slightly more sophisticated set of screens you could use. It's really secondary to the primary ones. But you can use it to fine tune, again, a special idea you have or a question you might have. "Hey, are there any retailers out there that are growing more than 10% a year that have a market cap in excess of $12 billion that also have an inventory turnover of more than 5x?" Someone who runs that screen will probably find TJX pops up, and that's a basis for further investigation on what might be a really great stock.

Shen: Thank you! We're running a little tight on time here. We have one last category, so I'll speak to this quickly, and that's with valuation. Going back to that car buying analogy, the price tag is obviously important. Some of our listeners might be perfectly happy paying for stocks that, for example, trade at triple-digit price-to-earnings multiples, or a really nice luxury car, because they believe that growth is valuable or that that model is what fills their needs and they can afford it. Others will have more strict guidelines based on things like price-to-earnings growth, price-to-sales if earnings aren't there. But the valuation category is kind of a nice metric to add on to your screen once you narrow down these different companies based on those other primary metrics that we've talked about in terms of really making that go/no-go strategy when it comes to either putting the company in your watch list or actually taking on a position.

Asit Sharma has no position in any of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool recommends The TJX Companies. The Motley Fool has a disclosure policy.

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