In today's global economy, weeding through vast amounts of information to arrive at an investment conclusion is very difficult. But, there are steps you can take to create a screening process to help sift through the large universe of ideas, and arrive at a manageable number that merit further investigation. Here, we'll take you through those steps.

TUTORIAL: Stock Basics

Step 1: The Broadest View
Some investors start their search with an industry, or theme, that has compelling drivers for growth, but is currently out of favor. As an example, prospects for growing household formation led some investors to favor building stocks after the real estate crash in the early 1990s. Others look for industries that are strong but still have room to grow, based on their positive long-term fundamentals. With the aging baby boomer population, healthcare has been such a theme in the 2000s. Choosing a theme can be a first step toward creating a smaller universe of stocks. (Learn more about how looking at the big picture can help you spot investment trends in A Top-Down Approach To Investing.)

Step 2: Company Statistics
Once a theme is established, whittling down the potential universe of stocks is necessary. Many investors have a particular company size they are comfortable with. Market capitalization of the firm, calculated by multiplying the number of shares outstanding by the current stock price, is a common measure of company size. Generally, firms are categorized as micro-, small-, mid- and large-capitalization, depending on the outstanding value of their stock. Most investors are familiar with the large-cap companies that are household names, such as General Electric (NYSE:GE), Proctor and Gamble (NYSE:PG) and Pfizer (NYSE:PFE). However, some themes focus on more obscure segments of the market, where only smaller companies participate, such as ethanol or modular rental companies.

After narrowing the potential list of companies by market capitalization, investors may review company characteristics, including growth prospects. If a company or industry is in the early stages of the business, or product life cycle, investors generally expect very high growth in sales, earnings or other relevant numbers. More mature companies are expected to display slower growth, but at a steadily rising rate. Growth also plays a role in dividend payments. Younger or high-growth companies usually reinvest free cash flows back into the company, while more mature companies may choose to use cash flow to pay above-average dividends.

Other components of a screen focus on a company's financial position, through financial ratios, such as liquidity ratios, debt ratios and profitability ratios. Liquidity ratios generally look at a company's cash, and short-term asset position relative to its short-term liabilities, and its ability to meet its short-term obligations, particularly working capital. Debt ratios generally look at a company's ability to service its debt obligations, and the size of a company's debts relative to its equity or assets. Finally, profitability ratios provide information about the return on assets employed, dollars invested or equity held. (Learn more about ratio analysis by reading Analyze Investments Quickly With Ratios.)

Another screen includes stock valuation parameters that help investors determine whether a stock price is attractive relative to the company's earnings, assets, book value and other characteristics. Common valuation multiples include price-to-earnings (P/E), price-to-sales (P/S), price-to-book (P/B) and enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA).

Step 3: Constructing the Screen
There are several professional software packages for screening, and some brokerage firms and public websites also offer much of this information. To construct a screen, according to the above criteria, investors first need to determine investment goals, particularly time horizon, tax implications and risk tolerance. Once goals are determined, investors can choose the criteria parameters used in the screen.

Example 1
A 22-year-old investor just landed his first job out of college, and wants to put some graduation gift money into some stocks. He has a long time horizon, wishes to minimize taxes and has a high risk tolerance. He feels comfortable with an early-stage company that offers high growth potential over the long term, but also higher risk than a more mature company. His screening criteria focus should be the following:
  • Early-stage industries
  • High revenue growth
  • Smaller market capitalization (less than $1 billion)
  • Ratios: early stage companies generally have unattractive ratios as they seek capital and spend more than they have to launch the business
  • Valuation: generally only P/S is a possible measure as earnings are typically negative
Example 2

A recently retired man with no dependents, other than a spouse, and no long-term debt generally has a lower risk tolerance, and needs to ensure his savings will last through the remainder of his life. This investor feels more comfortable with mature companies with lower growth potential. His screening criteria should focus on the following:
  • Mature industries
  • Low- or no-growth companies
  • Larger market capitalization
  • Ratios: strong liquidity and low debt ratios, high return ratios
  • Valuation: generally any ratio fits, but using P/E, P/B or EV/EBITDA are common; this investor should seek low multiples and high dividend yields

Step 4: Narrowing the Output
Even after the use of screens, many companies may still fit your criteria. Narrowing the list requires some further scrutiny about the particular companies, such as one's comfort level with the industry, or personal or social concerns. When the field is narrowed sufficiently, it is time to perform deep analysis of the company using all publicly available information, including the Securities and Exchange Commission filings and company or investor websites.

While an abundance of information and options can make investing overwhelming, understanding your investment goals and constructing a screen based on those goals, will help you select stocks that meet your needs. However, it is important to remember that these screening steps, while narrowing down the list of potential investment candidates, are no replacement for an in-depth fundamental analysis.

Related Articles
  1. Investing

    Spot Hotshot Penny Stocks

    Don't flip a coin to find your next investment.
  2. Options & Futures

    Tailoring Your Investment Plan

    Start your own investing adventure with the help of some simple guidelines.
  3. Investing Basics

    Getting To Know Stock Screeners

    Finding good stocks can be like finding a needle in a haystack. But these invaluable tools can help.
  4. Investing

    3 Healthy Financial Habits for 2016

    ”Winning” investors don't just set it and forget it. They consistently take steps to adapt their investment plan in the face of changing markets.
  5. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  6. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  7. Investing Basics

    4 Things That Make a Stock a Safe Bet

    No investment is a sure bet, but you can reduce your chances of taking a loss by choosing fair-priced stocks with growth potential and low volatility.
  8. Retirement

    Smart Ways to Tap Your Retirement Portfolio

    A rundown of strategies, from what to liquidate first to how much to withdraw, along with their tax consquences.
  9. Chart Advisor

    How Are You Trading The Breakdown In Growth Stocks? (VOOG, IWF)

    Based on the charts of these two ETFs, bearish traders will start turning their attention to growth stocks.
  10. Retirement

    Roth IRAs Tutorial

    This comprehensive guide goes through what a Roth IRA is and how to set one up, contribute to it and withdraw from it.
  1. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  2. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  3. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  4. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  5. How do I calculate the inventory turnover ratio?

    Managing inventory levels is important for most businesses and this is especially true for retailers and any company that ... Read Full Answer >>
  6. Does mutual fund manager tenure matter?

    Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>
Hot Definitions
  1. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  4. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  5. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
Trading Center