How to screen stocks

How to screen stocks

Knuckling Down with the Numbers ?

We’re at the business end of the best investing course out there! Today, we’re digging up great stock leads step-by-step, covering both some basic accounting and the various strategies of stock idea generation. Those include screening, reading 13Fs, themes, and specialisations. We’ll enlist the help of Gurufocus and Finviz to get underneath the most revealing metrics and measures for promising franchise value stocks, and the entire lesson is laced with little caveats of golden nuggets of advice to make all the difference. It’s an actionable banger of a lesson, so time to get stuck in!

Screening ?

Imagine filtering through a humungous database full of stocks for the winners. That’s what a screener lets you do. You’re narrowing down over 70,000 stocks to just a few well-scouted leads, the power of which is unrivalled.

However, done wrong, screeners are shortcuts for the lazy and false confidence for the spineless. To get the most of out a screener, compare its output to the source documents, i.e. check the business is as financially healthy as the screener suggests by looking at its financial statements. It’s not enough anymore to punch in parameters and take what’s given. You need to scrutinise what the screener spits out in light of the real context. The 10K documents with financial statements for a company can be found here. I recommend Gurufocus as your first choice all-in-one screener, with all countries selected. This is because Gurufocus’s scanning of markets outside America are great hunting grounds for poorly valued stocks. However, it costs. A more economical option might be Finviz Elite, where you can backtest experimental screeners. Both are very easy to use in terms of their interface!

How to screen stocks

How to screen stocks

The Mother of All Screens  ?

In a nutshell, this set of screening criteria will target stocks with franchise characteristics that may be selling at unduly low prices. It’s focused more on the quality of companies over their prices, which is the right way to do it in my opinion.

Percent the Stock Price is Above 52 Week Lows

This signals stocks that could’ve been oversold recently, perhaps not deserving to be sold at such low prices.

Relax the metric: with <25%, <30%, <50%, and so on.

Price to Book Value

 If a company sells for less than its book value, there are major red flags which inevitably will rule it out for us. That’s why we’re restricting the screener to stocks selling for more than their book value.

Book value is what all the tangible assets are worth in the business that you can touch, minus all the debts owed by the company. When the firm makes a profit but chooses not to pay it out as a dividend, that money will go into book value (assuming the money is sunk into a new tangible asset).

Tangible assets include cash, accounts receivables (revenues you’re owed from customers), property, plant and equipment (PPE), inventory (products in the back!), and so on! Most of the information about whether something is tangible or not can be found with a Google search.

The formula:

  1. Book value = Tangible assets – All liabilities
  2. Book value per share = Book value / Total common diluted shares outstanding
  3. Price to book value = Price / Book value per share

Statements needed: balance sheet, income statement.

Don’t relax this metric.

Debt to Equity

Debt is a good thing. It helps a company invest in growth sooner, so it can grow faster. Sometimes, it’s necessary to take on debt just to keep up with other companies. However, too much debt and the company will arrive at the Minksy Moment (the moment it realises it can’t pay off all the interest it owes).

There are different benchmarks for different industries. You can look them up online or in my resources section. The more reliable the revenues, the more debt can be taken on relative to equity.

The formula:

Debt to equity = Total liabilities / Total shareholders equity.

Statement needed: balance sheet.

This should be relaxed and tightened depending on the industry of the company. To relax, crank it up to >2, >3 etc.

Revenue Growth Rate over 5 Years

 Declining revenue over the medium-to-long term could indicate a dying industry. There’s no point investing in an industry whose days are numbered. We need to reach 30-50 years to compound, and investors will actually punish the stock years before the company itself goes extinct.

Statement needed: income statement.

Relax the metric: by setting it to >-1%, >-2%, or >-5% etc., or by removing it completely.

>Your desired yearly return from the stock as a % (you’re just setting a floor, this doesn’t mean you’ll get that return!)

 ROIC is the most important number you will work with as an investor. Unfortunately, working it out can be a right bastard!

It means return on invested capital and is a better equivalent to its cousin, ROE (return on equity). It’s defined as the returns made from profits reinvested back into the business and it’s crucially important to understand how ROIC is changing, why, and at what rate. That’s all in-store for the next lesson, don’t go anywhere!

The formula: NOPAT ÷ invested capital.

NOPAT (Net Operating Profit After Tax)

  1. Operating profit multiplied by (1-business tax rate) (operating profit is on the income statement and the tax rate can be googled or is commented on in the 10K so press ctrl-F and type “tax” to find it)
  2. So, a 20% tax rate implies (1-0.20), which would come out as operating profit x 0.80.
  3. Done, that’s NOPAT!

Invested Capital

  1. Do current liabilities that aren’t related to debt subtracted by current assets (Usually only accounts payable are liabilities not related to debt, but Google line items you’re not sure about in case there are any more. You’re looking for liabilities that have nothing to do with debt or ongoing interest payments of any sort!)
  2. Add PPE (property, plant, and equipment is an asset on the balance sheet)
  3. Add 2-5% of revenue (this strips out excess cash. Find revenue/sales on the income statement. Add 2% if a steady, established business, and 5% if it’s a new growth company)
  4. Goodwill is the amount of money the business has paid to buy other companies over and above what the equity added up to in those companies. The rules have it that sometimes, the business will need to write-off some of its goodwill figure, admitting it overpaid by some amount. Decide if the business will probably buy more companies in the future, and if not, don’t add goodwill. If you think yes, add goodwill. Stay afloat of the news however, because if write-offs are announced, you’ll need to take them off the goodwill you’re adding.
  5. Add the values of other assets on the balance sheet that you think are directly needed for the business to make money immediately.
  6. Done!

Then, divide NOPAT by invested capital to reach the real ROIC. Well done! ?

Payout Rate

Setting the payout rate to a small percentage of the company’s profits will ensure less than that percentage is paid to us as dividends. The opposite of a pay out rate is a retention rate. A 20% payout ratio would imply an 80% retention rate. Use either.

The formula:

  1. (1 – Dividends per share) / Free cash flow per share
  2. Free cash flow per share = Free cash flow / Shares outstanding

Statement needed: income statement.

I wouldn’t relax this metric. If you do, make it <21+%.

Insider Ownership

It’s a strong measure of management quality to see CEOs, presidents, and chairman investing in their own company. When they have skin the game, they’re likely to be friendly to other shareholders like us and make business decisions with extra care.

Relax the metric: by setting it to >19% or below. >3-4% is the effective floor.

Institutional Ownership

Institutions are banks, hedge funds, and other big money managers that are moving huge amounts of cash around the stock market. They have advantages that we don’t, making them for tough competition against us. If we can minimise the number of institutions invested in our stock prospects, we can instead compete against easier members of the public. 

Relax the metric: by setting the cap at 15.

Analyst Coverage

If there are less professional institutions in the stock, there are by definition, less professional analysts. Let’s be smart, let’s not try to compete against professional analysts. 

Relax the metric: by setting it to a number <5. If the company is huge, below <10.

Let’s Learn About Free Cash Flow ?

When a business sells a product, revenue comes in. That’s recorded on the top line of the income statement and can go by the name ‘sales’ or ‘net sales.’

Then, costs of making that sold product are shaved off to leave gross profit.

Then, costs of running the business are shaved off to leave operating profit.

Then, the interest owed on debt is paid, plus taxes, to leave net income.

Most people consider net income to be the end of things. It’s not! There are other costs that need taking into account, and when they’re shaved off too, you arrive at free cash flow. Free cash flow is the money we’re getting at the end of the day as investors. 

Capital Expenditures ?

Yikes, what a scary name! Don’t worry, you already know that when a company makes profit, it often reinvests it. ‘Growth‘ capital expenditures would be like a supermarket chain opening a new supermarket. Those “expenditures” are the company growing! However, if a supermarket chain refurbishes a store or does something else to maintain or repair a big, long-term asset it already owns, that’s ‘maintenance’ capital expenditures. It’s a vital distinction! The following steps to work out both types of capex are credited to Joel Greenblatt, one of the most successful investors of all time. I do still feel they leave us a bit short. Free cash flow is very important and the size these numbers can get mind-boggling.

Working out Growth Capex ✍

  1. Jot down the last 5 years of revenue/sales (top-line of income statement)
  2. Jot down the last 5 years of PPE which means Property, Plant, and Equipment (an asset on the balance sheet)
  3. For each year, divide the PPE number by the sales number and write it down as a percentage (percentage of PPE to sales)
  4. Work out the average of all the years
  5. Work out the sales growth of each year compared to the year before but not as a percentage, just as the dollar amount (may not always be positive growth!)
  6. Work out the average of all the years
  7. Multiply the avg. PPE/Sales percentage by the avg. sales growth you have written in dollars
  8. Done!

Working out Maintenance Capex ✍

  1. Jot down the last 5 years of overall capital expenditures (under ‘investing activities’ on the cash flow statement – sometimes referred to as additions to PPE)
  2. Work out the average of all the years
  3. From that average, subtract the final number you reached for growth capex in the prior calculation
  4. Done!
Net Working Capital ?

The second adjustment to net income after maintenance capex is much easier. Net working capital is the money that keeps you in business on a daily basis. You may owe debts due within a year, so net working capital is the money you have at hand to meet those obligations. If you have negative net working capital, uh-oh… In that situation, up and coming profits for the year will have to be spent on paying debt rather than on other things beneficial to us as investors. Let’s account for it!

Working out Change in Net Working Capital ✍

  1. Unearth last year’s balance sheet.
  2. Subtract accounts payable, accrued liabilities, and ‘other current liabilities’ (these are Current Liabilities that more represent expenses!) from accounts receivable, inventory, and prepaid expenses (these are Current Assets without cash or cash equivalents!)
  3. Repeat the process on the current year’s balance sheet.
  4. Work out the difference between the figures from each each.
  5. Done! That’s the change in net working capital.

After subtracting maintenance capital expenditures and the change in net working capital (be it positive or negative),  you get free cash flow! 

Bear in mind, the change in NWC could be a negative figure, so you’re subtracting a minus figure.

Form 13F ?

A 13F form is filed by fund managers, disclosing what they’re buying and selling. A fund manager is an investor who has been given others’ money to invest because of his or her talent (or snake oil salesmanship ?).

There’s a few months of lag time with what the 13F form shows, but copying the best in the business has to be a smart strategy for finding promising stock leads. It’s a no-brainer! You can check out fund 13Fs here, but first some words of advice;

Scrutinise the track record to ensure it’s consistently been picking winners for 10+ years

Choose funds managing less than a billion dollars

Prefer fund managers who concentrate money into their best ideas

Theme Investing ?

Some world trends are misguided. In the business world, negative sentiment is always hovering somewhere and if that sentiment is wrong, you can capitalise as an investor.

For example, retail is considered dead or dying by most in the market. Few market watchers are willing to pay a high price for retail stocks and so they’re very cheap, offering good yields. This may be justified if the true value in retail matches those prices, but if you have reason to think retail has a better future than most believe, focus on retail and analyse it in more detail to see if you’re right.

A common approach to theme investing is to wait until a large company befalls a major PR disaster. Scandals are your best friend. The investing public sells its shares all at once in a viral commotion, causing the stock price to plummet. In many cases, that’s an  unjustified emotional reaction and there’s a window of opportunity for you to buy low. Think Facebook in 2018, United Airlines in 2017, or drug-maker Mylan in 2016. Every year, you’ve got opportunities.

Avoid political themes that bring on speculation

Remember negative sentiment is only wrong if profits go be unaffected by the scandal

Be humble, admit what you don’t know

Don’t fall in love with your big picture ideas or world view

Specialisation ?

Saving the best until last, specialising in a small niche of the market has fast become one of the best ways to outperform it. You can hone in on an industry you like, or one that you already have connections and work experience in. The goal is to become the number one investor of that space with the best insights and understanding, so learn, learn, learn! Opportunities will flash up on your radar whereas they won’t for others who spread themselves thin over the entire market.

You can specialise in industries, countries (certain stock exchanges), special situations, or even better still, something nobody has thought of yet!   Roam this website to get started. I’ve packed it chock-full of industry insights worth paying for, but I’ve kept it free. Just peruse my content until you find a niche that sparks an itch. My industry primers would be the best place to start!


Chris Morrissey

Chris started in financial advisory, assembling client portfolios with pension companies and investment banks. Following that, he worked at an agricultural commodities trader in London and now various "fintech" start-ups. He's also studying business full-time at Lancaster University. Feel bewildered by the stock market? Chris will help you get things under control.

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