Choosing a stock is quite complex especially considering that there are thousands of heterogeneous stocks in the market from different industries with varied business models. This is where screeners come in handy.
What are screeners?
Screeners are basically automated filters for shortlisting stocks based on specific criteria.
Let us explain their use with an example: the investment committee of a mutual fund may have decided that they would only buy stocks that have net profit margins of more than 10% and return on equity (ROE) of more than 20%. Alternatively, an investor may have come to the conclusion that the best stocks to select are those where the ROE is greater than the return on capital employed (ROCE), both being above 15%. These kinds of complex combinations can be built into your screeners and used to shortlist stocks that suit your needs.
Screeners allow you to shortlist your choice of stocks based on financial criteria. Screeners are useful not only in isolation but also as a combination. Let us look at four such key screeners and then see how to combine them more meaningfully.
Check for profit performers with profitability ratios
A profitability screener allows you to screen and shortlist stocks based on their profitability. For example, you can filter stocks based on operating profits, gross profits, EBITDA, pre-tax profits, or on the basis of net profits. You can also look at stocks in terms of reward on capital, and use screeners such as ROE and ROCE. In fact, you can also use combinations of profitability screeners as under:
I am looking for companies with =>=> NPM > 10% and OPM > 20%
I am looking for companies with =>=> ROCE > ROE and OPM > 25%
Efficiency matters a lot more when it comes to sustaining profits
Efficiency screeners measure how efficiently assets are turned over for the level of sales. For example, if the sales are thrice the size of assets, the asset turnover ratio is 3 (which shows a healthy level of asset efficiency). It shows that the company is able to churn the asset value thrice over the year to generate substantially higher sales. You can also have screeners based on fixed asset efficiency, core capital efficiency, working capital efficiency, etc.
I am looking for companies with =>=> Current Ratio > 1.50 and Quick Ratio > 1.20
I am looking for companies with =>=> Asset Turnover > 1.75 and Fixed Asset Turnover > 2.50
It is all about solvency in tough times
The inclusion of debt in the capital structure works both ways. It reduces the cost of capital but, on the other hand, adds to your financial risk. Debt has to be serviced in terms of interest and principal repayments. Solvency screeners are a sounding board on whether to invest in the stock or not.
I am looking for companies with =>=> Interest Coverage > 3 and Debt / Equity < 1.50
I am looking for companies with =>=> Interest Coverage > 2 and DSCR > 1.50
Finally, all screeners boil down to valuations
This is the last ratio screener to shortlist stocks. There are different approaches to valuation screeners. These can be based on P/E ratio, past price performance, P/BV for select industries, dividend yield, etc. These ratios are all about valuation comfort for the investor. You can also have screeners based on margin of safety.
I am looking for companies with =>=> Margin of Safety > 30%
I am looking for companies with =>=> Margin of Safety > 20% and P/E < 15
Make the most of screeners by combining them
The real value addition in screeners is visible when you combine different heads like profitability, efficiency, solvency, and valuations and arrive at actionable inputs. You can manage that by setting multiple conditions at the same time. Typically, you do not screen these ratios as discrete variables but as combinations. Look at some such examples:
Screen for =>=> NPM > 10% .or. ROE > 25% and P/E Ratio < 12X
Screen for =>=> Asset Turnover > 2.50 or Fixed Asset turnover > 3.50 and Interest coverage > 2.20
In the above instance, we have combined different headers of screeners so that you can take a more holistic view of companies. This can be a useful step in shortlisting stocks post which the actual stock drilling can begin. Alternatively, these screeners can also be used as part of your bottom-up approach to ratify your view on stocks.