If you've ever looked at a newspaper's endless stock listings and heaved a sigh of despair at the thought of finding some terrific investments amid thousands of contenders, rejoice! There's a tool at your disposal that can help you winnow some winners. It's called screening.
When screening for investments, you employ a filter. It's made up of a set of parameters describing what you're looking for. For example, you might want to find companies with market caps above $50 billion and/or those with no debt. Screening can help you find a bunch of companies that match many of your criteria. It's a way to possibly find tomorrow's Wal-Mart
There are a bunch of websites, such as CBS MarketWatch and Yahoo!, that offer free screening tools you can use. Then there are others, such as Hoover's, that offer screening tools only if you cough up a little money. One stock screener that many at Fool HQ like costs even more, but might be of interest: Stock Investor Pro.
How to screen
Once you're staring at a stock screener, you simply set parameters for one or more variables and run the screen to see what you get. It can be as simple as that. But sometimes you'll get too many or too few companies. Or maybe you'll get the kinds of companies you're not interested in (Amalgamated Litter, Cigar Butts "R" Us, Mold Supply Co.). To get around this, it's smart to do some tweaking.
If you got 600 companies returned to you and one of your parameters is a price-to-earnings (P/E) ratio of 0 to 50, then you might reduce that to 0 to 40 and see how much smaller your list gets. If it's still too big, you can reduce it to 10 to 30, and/or you can tweak some other variable. Maybe add or delete some variables. Generally, the more variables you screen for, the smaller your list will tend to be.
Screens can be ruthless, though. If a company meets four of your five criteria but misses the mark on one, it won't be included in your results and you'll likely miss it. If you set P/E parameters for 10-35, there might be an amazing company out there that meets all your other screening criteria, but has a P/E of 37, so it won't show up. If you widen your parameters, you'll be more likely to catch more such companies. But you'll also end up with more chaff.
Remember that your results are just a beginning. Once you've arrived at a manageable group of companies, you'll need to research them to see if they really pass muster as worthy investments. For example, a company might look great according to the six criteria you screened for, but upon closer inspection, you might discover that it's embroiled in legal troubles or has a new CEO of questionable quality or it's in an industry you'd rather not invest in, such as tobacco.
So be sure to continue screening by checking out your group of candidates to see which ones pass all or enough of your other requirements. (These might include a strong competitive position, a promising strategy for growth, an attractive price, etc.)
If you plan to take screening seriously and do a lot of it, keep records. If you want to make sure you're screening for the right kinds of things, you might screen, research your results, decide which companies in the group you would buy, without actually buying them. Instead, add them to a mock or paper portfolio and follow them for up to a year or longer, seeing if they turn out to have been sound choices. What you learn may help you fine-tune your screening and might also offer insights into what you should look for in companies and how you want to evaluate them. Even failures can be instructive -- sometimes more so than successes.
Variables you can screen for
There are hundreds of variables you can screen for. Some examples:
Index or industry classifications: You can search through just companies in one or more particular industries or in a certain index. For example: just software companies or just companies in the S&P 500.
Size: You can look for companies of a particular size, measured by factors such as market capitalization or revenues or earnings. (Market cap is an approximate price tag for a company, determined by multiplying the current stock price by the number of outstanding shares. It's the total value of all existing shares.)
Growth rates: You can seek out companies that sport particular growth rates for revenues, earnings, earnings per share (EPS), stock price, dividends, and other measures. You can also look for firms that analysts expect to grow at certain rates in the next few years.
Margins: You can seek certain ranges of profit margins. Remember that the three key margins are gross margin (subtracting cost of sales from revenues and dividing revenues by the result), operating margin (dividing operating margin by revenues) and net profit margin (dividing net income, or earnings, by revenues).
P/E ratio: This divides the current stock price by earnings per share for the past 12 months. ("Forward P/E" uses an estimate of EPS for next year.) The lower the P/E, the more attractive the stock price -- although remember that P/E ranges vary widely by industry, so what looks low for one company might be high for another.
Current ratio, quick ratio, debt-to-equity: These ratios help you get a handle on a company's debt and its ability to pay its obligations. In general, the higher the quick or current ratio, the more a company is able to pay off debts. The lower the debt-to-equity ratio, the smaller the company's debt load.
Returns: To gauge a company's efficiency or profitability, you might look at return on equity (ROE) or return on invested capital (ROIC) or return on assets (ROA). The higher the number, the better. (Explaining various returns can be a bit complicated, but you'll find some information here and here.)
Volume: You can look for stocks that are experiencing a certain range of daily (or monthly) dollar volume -- meaning that so many dollars' worth of shares are trading hands each day.
- Other factors: You can screen for certain ranges of dividend yield, dividend growth rate, beta, relative strength, market share, stock price, percentage of shares held by institutions or insiders, and much more.
Screening isn't a silver bullet. Though it can help you find stocks to buy, you'll still need to develop a selling strategy.
Screening is also dependent on the accuracy of the underlying data. If your screen is using some bad numbers, which can happen, your results won't be reliable. In addition, since accounting rules permit manipulation of many numbers such as earnings, even "good" numbers can be problematic.
Screening is pretty much limited to quantitative factors. It's hard (and often impossible) to screen in an automated fashion for management talent, brand strength, competitive position, industry characteristics, CEO hairstyle, etc.
The popularity of some screens can possibly reduce their effectiveness. For example, if everyone is out looking for high-dividend stocks and they snap up shares in droves, then the prices of those stocks will increase and their dividend yields will fall, reducing the number of high-dividend stocks available.
Finally, if you'll permit me a moment of promotion, let me point out that if you're interested in letting Fool analysts do the work of searching for promising investments, you should check out our suite of stock newsletters, which deliver exciting ideas each month, with impressive results so far.
Longtime Fool contributor Selena Maranjian even finds screen doors interesting. She owns shares of Microsoft. For more about Selena, view her bio and her profile . You might also be interested in these books she has written or co-written: The Motley Fool Money Guide and The Motley Fool Investment Guide for Teens . The Motley Fool is Fools writing for Fools.