7/29/08

Using Stock Screeners for Beginners

This post is intended mainly for new investors.

A stock screener is a great tool for initial stock research. There are thousands of stocks out there. Stock screeners can be used to whittle these thousands down to a small handful, depending on the criteria you use.

I'll be using Yahoo's screener here, as MSN's (which is more powerful) only works with Internet Explorer (but not IE8 Beta last time I tried it) and Windows, and some people may not have this software. Where relevant, I will mention the MSN screener.

Before using a stock screener, you should have an idea of what kinds of stocks you're looking for, e.g., companies with overall great records, large cap value, small cap growth, mid cap basic materials companies with dividend yields greater than 2%, etc.

When you load the Yahoo screener, you'll see a "click to add criteria" button. Clicking on this will give you a drop down menu of 13 categories, each of which have several criteria.

Let's go through a couple of simple screens to see how it works.

A Simple Screen: Dogs of the Dow

You probably heard of the Dogs of the Dow. These are the ten highest dividend yielding companies in the Dow Jones Industrial Average. If you're interested in the investing strategy, click here.

Let's use the screener to find the dogs. Click on "click to add criteria," go to "descriptive," and then "index."



You'll see that in the column with the heading "Conditions" there now appears "select a condition" in green. Clicking on this, you'll see that there's only one choice, an equals sign ("="). (You will have more choices depending on the criteria you selected). Click on the equals sign.


Now you'll see "Select a Value" show up under the "Values" heading. Here you have two choices, S&P 500 and Dow Jones Industrial Average (DJIA). Had Yahoo's screener been more powerful, more indexes would be listed.

Since we're looking for the Dogs of the Dow, select "djia." If you click on the "Run Screen" button, you should get the 30 components of the DJIA. Here's a great example of why screeners should only be used for preliminary research and shouldn't be completely trusted. Running this screen resulted in 29 matches. Alcoa (AA) is missing from the list for some reason. (If you're curious, screening for the S&P 500 has the same error. It results in 499 matches, although I'm not sure which company is excluded.)



Let's pretend the error didn't occur.

The other criterion in being a dog is being one of the top ten highest yielding Dow components. So, click on "Click to add Criteria," then on "dividends," and then on "yield."

In the conditions column, you'll find a choice of greater than or equal to (">="), less than or equal to ("<=") and "between," from which you can select a range of values. MSN's more powerful screener has other options, including "high as possible" and "display only." If you were using MSN's screener, you'd click on "display only." Since we don't have this choice here, however, click on ">=."

Since our criterion is yield, the number we enter in the values field will be a percent. So, suppose you enter "2." What you're really entering is 2%. This would mean that you're screening for companies with a dividend yield greater than or equal to 2%.

While all the Dogs of the Dow currently yield over 3.5% (as of writing), this is not always the case. It's possible, though unlikely, that they can yield less than 1%. If this were to happen, I'd stay away, as they probably would be grossly overvalued. Given that the yields can vary, select "0" in the values column.

This screen will give you all the DJIA components with a yield greater than or equal to zero (because of the error, mentioned above, the screener only gives you 29 companies, but we'll ignore that). When you click on the "Run Screen" button, the companies displayed in your results won't change. However, you'll notice that in the results you now have an extra column, "yield." By clicking on it, you can sort your results. When you sort yield by descending order (company with the highest yield goes first), your top ten results are the Dogs of the Dow.



But wait. Here's another example of how stock screeners can give you bad information. Notice that General Motors is in the second spot. The company recently eliminated its dividend. Yahoo has not updated its data to reflect this yet (at the time I ran the screen, anyway). As of writing, then, the Dogs of the Dow are Bank of America, Pfizer, Citigroup, AT&T, Verizon, Merck, GE, JP Morgan Chase, Home Depot, and Du Pont. (Remember to check Alcoa, since it's not listed in the results. It happens to yield just over 2%, while Du Pont yields around 3.7%. So our list is not affected, but it could have been).


Slightly More Complicated Screen

Let's run another screen. Clicking on the "New Screen" button will reset the stock screener (if you want, you can save and/or export your results before resetting the screener by clicking on the file menu).

Let's go for something a bit more complicated. Say we're looking for a company with a decent record of performance, and a solid balance sheet. Beyond the extremes, every investor's opinion of what constitutes good performance and what makes for a solid balance sheet is different. The figures presented here are for demonstration purposes only.

Let's start with the balance sheet. Luckily for us, the Yahoo screener has a category called "Balance Sheet." Other screeners may have something like "financial health" or "financial strength" instead of "balance sheet."

I'll go through each of the nine criteria in the balance sheet category that Yahoo lists.

1. Price Book Ratio is determined by dividing the company's stock price by its book value per share. Another way to get this figure is to divide the company's market capitalization by its book value. Book value is how much you would have left over if you sold all the company's assets (buildings, trucks, chairs, computers, cash, etc) and paid all its liabilities. Divide this number by the number of shares the company has outstanding, and you have its book value per share. Dividing the stock's price by book value per share gives you the price/book ratio. An argument can be made that this is really a valuation measure and shouldn't be in the balance sheet category.

Most stocks trade at price book ratios of more than 1. This is because investors are willing to pay more than just a company's liquidation value. For example, there's more to Pepsi than its office equipment.

When companies trade at price book ratios of less than one, there are usually two or three possibilities. Either the market isn't paying attention to the company or is irrationally discounting its value, the market does not believe that the company's book value really is whatever number is reported, or the market believes that the book value will decline in the future.

Generally speaking, buying a stock with a price book ratio of less than 1 means you're buying the company for less than its liquidation value. If it were closed today and all its assets were sold, you would make a profit. However, take a look at how financial stocks have traded recently. Some have had their price/book ratios go below 1. This indicates that investors think the companies' book values are lower than reported or can quickly become so. The next write down, it seems, can be just around the corner.

However, also generally speaking, the lower the price book ratio is, the better. For example, master investor Benjamin Graham liked companies with price book ratios of 0.66 or less.

2. Cash per share is how much cash plus cash equivalents the company has, less its short term debt, divided by the number of shares outstanding. This figure is more useful as a percentage of share price. For example, having $20 cash per share doesn't say much until we know how much the stock trades for. There's a difference between a stock trading at $1,000 with $20 per share and a stock trading at $100 with $20 per share. While higher numbers (compared to share price) are usually better, an unusually high number, say more cash per share than the share price, can be a sign that the company is experiencing problems.

3. Total cash is the sum of the company's cash and cash equivalents.

4. Book value was explained above in the price book ratio.

5. Total debt is the sum of all the debt the company has.

6. Total Debt/Equity is total debt divided by the shareholders' equity, which is all the company's assets minus all the company's debt. Generally speaking, the smaller this number, the better. A company with a total debt/equity ratio of 0 has no debt. Usually, this ratio should be put in context. Compare it with the average of the industry the company is in. Having a debt equity ratio of below industry average is generally a good thing. But note that a company can grow earnings faster with more debt. (Think of buying stocks on margin; your potential gains are greater--but so are your loses).

More powerful screeners have something called "interest coverage ratio," which is the company's earnings before interest expenses and taxes divided by interest expenses. The higher this ratio the better. Generally, look for companies with an interest coverage ratio of greater than 1.5.

7. Current Ratio is determined by dividing the company's current assets by its current liabilities. We've seen what assets are above (in price book ratio). Current assets are things that are more readily available, like cash, accounts receivable, and inventory. Liabilities are what the company owes, like its bills and debt. Current liabilities are those that are due soon, within a year or so.

The higher the current ratio, the better. Let's say a company's current assets are $5 million and its current liabilities (debt and other payables due soon) are $1 million. The company's current ratio is 5. This company can pay all its current debts and have enough left over for unforeseen expenses as well as opportunities.

A current ratio of less than 1 indicates that the company has less current assets than current liabilities. For most companies this is not a very good sign. But consider a giant like Procter & Gamble. As of writing, the company's current ratio is less than 1. Does that mean it'll go out of business? Hardly. But for a smaller company, one that cannot borrow as freely, a current ratio of less than one may be a sign of trouble.

Screening for companies with a current ratio of 2 or higher is generally a good idea, but note that you'll probably eliminate companies like Procter & Gamble from your results. As with debt/equity, a company's current ratio may be more illuminating if it is compared with its industry's average.

8. Long Term Debt/Equity is the company's long term debt (usually debt due in more than a year) divided by shareholders' equity. Again, the lower this number is, the better. But look at the industry average to put it in context.

9. Quick Ratio is like the current ratio. It is determined by dividing the sum of the company's cash and cash equivalents (inventory isn't included) by its current liabilities. This ratio shows how well as company can respond to sudden expenses or opportunities. Does it need to take out a loan, or can it just pay with cash? As with the current ratio, the higher the quick ratio the better.

Let's screen for companies with solid balance sheets.

Let's make Total Debt/Equity <= 3.5 and Long Term Debt/Equity <= 3.5. This will screen out all the outrageously leveraged companies. Note that there will still be plenty of companies with too much debt, but putting these ratios too low will screen out companies in capital intensive industries. If we were using a more powerful screener, like MSN's, instead of putting in actual numbers, we could have used "<= industry average" in the value field for better results.

Next, let's make the current ratio >= 2, and the quick ratio >= 0.5. (Again, with MSN's screener we can use industry average to put the results in context.)

Let's make the price to book ratio <= 2. This brings our number of matches down to 535. Still an unmanageable amount.

Let's look beyond the balance sheet to the company's valuation and past performance. There are a number of various ratios. Here are the ones I use most.

1. Price Sales Ratio (P/S in the "valuation" category in Yahoo's screener). This is determined by dividing the stock's price by its sales revenue per share. Sales revenue per share is the company's sales revenue over the last 12 months divided by the number of shares outstanding. This ratio is more useful to look at than the Price Earnings ratio (P/E) because sales figures are harder to fudge. Note, though, as with all per share figures, the number of shares has an effect. For example, the sales per share figure can grow while the company's actual sales remain flat or decline. How? A company can decrease the number of shares outstanding by buying back stock. Also note that sales say nothing about the company's profits. If costs rise, a company can post lower profits on higher sales.

Generally speaking, the lower the price/sales ratio, the better. But setting the ratio too low can make you miss out on good companies.

2. Return on Equity (in the "profitability" category in the Yahoo screener, may be called ROE in other screeners) is determined by dividing the company's net income by shareholders' equity. Net income is all the money the company takes in less all its costs (taxes, depreciation, interest payments, etc). Return on equity measures how much profit a company makes on its shareholders' investments. The bigger this number is, the better.

3. Net Profit Margin (Profit Margin ttm in Yahoo screener) is the company's net profits divided by total revenues for the last 12 months. The higher this number is, the better. It is useful to compare this ratio to the company's industry average. Don't expect a leading supermarket chain to have margins higher than a leading software company. Having above industry average profit margins usually indicates that the company is an industry leader that commands more pricing power or has lower costs.

Let's make the price sales ratio <= 5 (you can fiddle with this one), return on equity >= 20, and net profit margin >= 20.

This gives us a total of 14 matches: DRYS, ESEA, EXM, FSTR, HLTH, ITRN, NWD, ORH, RDC, SGY, UWN, and YZC. All of these companies have solid balance sheets and decent margins and returns on equity. They're also not too expensive based on their sales.

Are they good investments? Beats me. Further research is required. I'd like to know a lot more about each company before buying or shorting it. What is its earnings growth like, is it accelerating, who's in charge, are there opportunities for growth in the future, do they pay a dividend, what does the company do, who are its customers, are margins widening or contracting, etc? Some of these can be screened for, but provided the list isn't very large I like to look at the companies individually.

Remember that a stock screener's results are only as good as its underlying data. There can also be flaws with the screener itself, as we saw with the Dogs of the Dow screen. Regarding the underlying data, always use more than one source for each company you research. Look at the company data on Yahoo, Google, MSN, MarketWatch, etc. You'll no doubt notice that the figures for the same company are different depending on the data provider. This is because the data provided are often from different periods and are usually based on per share amounts. If in doubt, consult the investor relations site of the company in question.

This should be stressed, a stock screen should be the first step in a much longer research process. Stock screeners are for generating ideas for further research and limiting the number of companies you go through. They are never buy recommendations.

I hope this was useful practice for novice investors and made stock screeners a little less confusing. Hopefully seasoned investors got something out of this too.