4 Steps To Picking A Stock

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.

Conclusion
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.

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