Wednesday, September 28, 2011

Lesson 10: My screening process

After screening for stocks with a PE ratio under ~15 and return on equity higher than ~15, I still can end up with lots of stocks (sometimes around 200). I'd like to give a quick outline of what I look for. All criteria must apply to the company for the previous 4 years or I will almost always disqualify them. I've listed each one in the order that I follow. I use google finance for financial statements.

1) The company must have positive (and hopefully increasing) earnings
2) The company must have positive operating cash flow.
3) Shareholder equity must be increasing each year, or there must be dividends/repurchases to justify a lag in shareholder equity.
4) Outstanding shares cannot be increasing at high rate.
5) Total debt must be smaller than 3 times the operating cash.
6) Capital expenditures must be less than half of operating cash.
7) Accounts receivables must not be growing at a rate faster than revenues.

All of these generally take less than 2 minutes to scan through. If a stock passes all of these, I would look more closely at things like inventory, unusual expenses, issuance/retirement of stock, and finally, the 10K Going through 10K's are a lot of work, so I reserve them for the best looking companies. It's rare to find marginal or bad companies that suddenly become good. If I were to comb every 10K for these, I wouldn't have enough time in my whole life to go through every company.

I have to announce that I cannot properly analyze banks, pharmaceuticals, foreign and commodity related stocks. They usually outside my circle of competence and I generally stay away from them. Perhaps someone else could shed some light, as I always want to learn more.


  1. Hi Ri.

    When you talk about return on equity what exactly do you mean. Is it a general encompassing term for one of the following:
    1- dividends i.e. 15 cent on the dollar
    2- capital gains i.e. 15% annual return

    Also why is a PE of 15% considered a good ball park figure?


  2. Return on equity is net income divided by shareholder equity. It is a measure of efficiency. Imagine you are running a coffee business. You buy a coffee machine for 100 dollars and you make 20 dollars in profit for the day. Your ROE would be 20% (per day). If instead you make 40 dollars each day, your ROE would be 40% (per day). If your competitor next door needed to buy 2 coffee machines in order to make twice the coffee to make 40 dollars each day, you have clearly out performed him by needing less equipment to make the same amount of money. If you require less equipment in order to generate the same amount of profit, you are more efficient (maybe you ran things better and needed fewer workers, or something).

    The PE of 15 (not 15%) just happens to be what I use to filter out companies. I'm looking for the best companies, so I want to look at maybe the top 80 companies out of the 10's of thousands. You can modify this criteria to let in or filter out more companies. What it comes down to though, is that you have a finite amount of time, and you only want to look at the best 80 (or 50, 30, etc) companies out of all the ones that exist.