There are many choices in investing. The New York Stock exchange lists over 2,800 companies alone, and the NASDAQ has another 2,500+. With so many stocks to chose from, how do you pick the right ones since not every company that is listed is a good one or worth investing in? For every Google and Apple there is a Primerica and Enron. To cut out the junk and focus on the quality you need a strategy to narrow the field so only companies that align with your beliefs are left.
In order to achieve that you need to chose criteria that you can easily apply to your search and is readily available in free stock screeners such as Google and Yahoo!. There’s a good chance that your brokerage account also has this screener.
1. Market Cap
The first thing you should filter on is Market Capitalization. This is one of the easiest things to apply and is available in just about every free stock screening service. Market cap is pretty objective so selecting companies with a market cap above $500 Million is straight forward. If a company doesn’t make the cut, then there is no room for justification of investing in companies smaller than that market cap.
Why $500 Million? The goal is to get to companies that have strong balance sheets with long track records of performance. Any company with market caps below $500 Million are typically not large enough to sustain shocks to markets, and are also characteristic of companies that are in their growth stage where generating Free Cash Flow is not a priority. Using this screen is the fastest way to exclude companies that would not make the cut when you do an in depth analysis.
2. Return on Equity
Return on Equity (ROE) is also something that is easy to screen, and you should look for companies with a ROE of 10% or above. ROE is defined as net income divided by shareholders equity, or in other words how much profit it generates with the money that shareholders have invested. The value of this ratio is that it tells you how effective management has been in running the company. The good thing about this ratio, like market cap, is that it is clear how to filter out companies that don’t make the cut.
3. Debt to Equity
Debt to Equity (D/E) is another easy filter to apply to a stock screener. Debt to equity is defined as the value of total liabilities divided by shareholders equity. Value companies are typically not heavily in debt so selecting a Debt to Equity ratio below 1 will exclude a lot of stocks that you would end up eliminating later anyway once you started to evaluate it’s financial statements. With that said, if you find yourself looking at a company with a Debt to Equity ratio that is between 1 and 2, it may still be a good company to invest in if the company has recently taken on debt to finance the expansion of its business. Long trends with D/E above 1 should be a cautionary tale however, and should be avoided.
4. Price to Sales
Price to Sales ratio (P/S) will screen out lots of companies and can be used to narrow the field after you’ve applied all of the other screeners. We have previously written about P/S and the research done as a predictor of future stock performance. The rule of thumb is that the lower the P/S the better, but anything below 1 indicates that the company sells lots of its goods and services.
These screeners are designed to reduce the universe of possible companies to invest in so that you can focus your attention on a few companies to research. Remember that this is a great place to start your research not the final or only thing that you should do as part of your research.