Using stock screeners as part of your investment process is a critical step to beating the market as it will uncover great and unique investment ideas! Without using screeners, investors are prone to fall victim to herd mentality investing, where they are only being exposed to already popular investment ideas through various media sources instead of doing their own independent research.
Using a little algebra within screeners, investors can combine minimums or maximums for various fundamental metrics in order to only bring up stocks that meet popular rule-of-thumb investment criteria such as the PEG ratio and Investors’ Adjusted ROE, which this article will use as examples.
eInvesting for Beginners has a comprehensive guide on how-to use screeners with a great how-to video from Andrew on using Finviz (a free online tool!). Many online brokers also supply investors with screening tools within their platform as part of their overall product package, so take a look at what screening tools your brokerage offers too.
This article is the next step in using screeners and will get more advanced by teaching investors how to combine various fundamental metrics in order to build popular rule-of-thumb ratios in order to further narrow down the search for great investment opportunities!
Having Fun with Algebra in Stock Screeners!
Lots of the most popular rule-of-thumb investment benchmarks are the result of simply combining a couple of standalone metrics. Knowing the formulas and the rule-of-thumb output one is willing to accept, investors can easily create great screeners using some simple algebra. This can be done by combining various minimums and maximums for standalone fundamental metrics into a single investment screener. The result of the screener will always be within the rule-of-thumb and the standalone metrics can be adjusted appropriately for different levels of quality. Just how simple this is will be realized as we walk through a couple of examples below!
Building a PEG Ratio into Stock Screeners
Legendary investor Peter Lynch popularized the Price/Earnings to Growth ratio (PEG ratio) with his rule of thumb being that a company’s P/E ratio should be equal to its growth rate to yield a PEG ratio of 1x, and also that a PEG ratio of 2x signifies that investors are paying too much for growth. We can build this rule-of-thumb into a screener by setting a maximum for P/E and a minimum for growth rates as can be seen in the example below.
- P/E is less than 15x
- Growth is more than 7.5%
This stock screener will only return stocks whose PEG ratio is less than 2x.
We can also build different versions of the screener where we accept higher minimum P/E ratios in return for higher minimum growth rates (or vice versa!) but still keep the net result of the equation below 2x.
Screening for Investors’ Adjusted Return on Equity
Investors’ Adjusted ROE is my personal favorite ratio to help narrow down investment opportunities. As a rule of thumb, I look for opportunities with an Investors’ Adjusted ROE higher than 9%, as this is the opportunity cost I expect from historical passive stock market returns. This yield can be achieved by combining say, a 20% ROE, with a company trading at 2.2x price-to-book value.
- ROE is greater than 20%
- P/B is less than 2.2x
This stock screener will only return stocks whose Investors’ Adjusted ROE is less than 9%.
We can also build different versions of the screener where we accept lower ROE in exchange for lower book value (or vice versa!) and keep the net result of the equation above 9%.
Moving Up and Down the Quality Spectrum
Once investors get familiar with manipulating their favorite metrics using a little algebra, they can start to build different versions of their favorite metrics while always keeping trusted rule-of-thumb benchmarks intact. These different versions can be thought of as higher or lower quality where certain variables in the formula are prioritized in exchange for accepting less desirable values of the other variables. For my favorite saved screeners, I generally have three versions to isolate the highest, lowest, and average quality opportunities.
In higher quality versions of a stock screener, we are looking for companies with great profitability or growth characteristics while price is less of a concern. Standalone metrics such as return on equity or growth are adjusted upwards with price metrics making up the difference.
In lower quality versions of a formula, price is becoming the more important factor. Lower prices (as seen in P/E or P/B) are being screened for with profitability and growth rates making up the difference.
Takeaway for Investors
Great asset management firms have their analysts refreshing screeners every morning to see whether any new investment opportunities have sprung up which need to be further investigated! Retail investors should be doing the same to uncover new interesting opportunities!