Screening is a process to filter investments (for example stocks, bonds) based on a set of criteria. The criteria may be a set of financial ratios, or other metrics such as dividends paid, market capitalization, etc. One example of a stock screen is defined below.
|Criterion||Stocks Meeting Criterion|
|P/E < 15||100|
|Assets/Equity < 2||50|
|Dividends > 0||75|
|Meeting all three criteria collectively||25|
The criteria are not limited to the factors mentioned above. It can be as detailed and as specific as required based on the investment requirement. For example, if an analyst wants to keep risk low, he might screen for companies with positive earnings and a low leverage ratio (assets/equity). If he wants low P/E firms which are financially strong, he might use criteria such as P/E less than 10, and debt/equity less than 0.2.
Types of Investors
Stock screens are used by both growth and value investors.
Often, an analyst may be interested in finding how a portfolio based on a stock screen would have performed historically. For instance, assume you go back 5 years and apply the same stock screen to form a portfolio of stocks to see how much the portfolio would have earned had the strategy been implemented. However, there are some limitations (biases) to this approach:
When comparing ratios of companies using different accounting standards, adjustments may be required. Before making adjustments, consider the following:
Analyst Adjustments Related to Investments
Assume Company A classifies financial assets as “available for sale” and Company B classifies similar assets as “trading” securities. Adjustments must be made to classification of investments to facilitate comparison. Recall the following rules for classifying financial assets from the reading on balance sheets:
|Classification of Financial Assets|
|Measured at fair value through profit or loss: trading securities in US GAAP.||Unrealized gains or losses reported in income statement.|
|Measured at fair value through other comprehensive income: available for sale (AFS) securities in US GAAP.||Unrealized gains or losses recognized in equity.|
Analyst Adjustments for Inventory
Consider two companies reporting under US GAAP: one uses LIFO while the other uses FIFO. Companies using LIFO are also required to report a LIFO reserve. When LIFO reserve is added to LIFO inventory, we get inventory value under FIFO.
To make the results of the two companies comparable, the inventory values of the company following LIFO must be adjusted to FIFO using the following formula:
FIFO Inventory = LIFO inventory + LIFO Reserve
Analyst Adjustments Related to Property, Plant, and Equipment
Any company’s management exercises considerable discretion when it comes to estimates and accounting methods for depreciation. Depreciation expense can significantly impact the net income of company and fixed assets on the balance sheet. So, it depends whether a company is making aggressive or conservative estimates for the useful life and residual value of its assets.
Specific adjustments are usually not made for depreciation when comparing two companies. It is more of a qualitative factor. The table below is self-explanatory; it lists the relationships between assets and depreciation as seen in the balance sheet and income statement.
|Number of years of useful life which have passed.||Accumulated depreciation/ gross PPE|
|Number of years of depreciation expense which have been recognized.||Accumulated depreciation/depreciation expense|
|How many years of useful life remain for the company’s overall asset base?||Net PPE (net of accumulated depreciation)/depreciation expense|
|Average life of the assets at installation.||Gross PPE/depreciation expense|
|What percentage of the asset base is being renewed through new capital investment?||Capital expenditure/ sum of gross PPE & capital expenditure|
Analyst Adjustments Related to Goodwill
Goodwill arises when one business acquires another business. If the purchase price exceeds the sum of the fair value of the individual assets and liabilities of the acquired business, then the excess amount is recognized as goodwill. Let us assume that companies A and B are identical except that A has grown through acquisition and B has grown organically. What is the impact on goodwill and on total assets?
The company that has grown through acquisition will record higher goodwill, assets, and equity. Assets are higher for this company as they are capitalized and not expensed like the organically growing company. The ratios based on asset values, including profitability ratios, look better for the grown-by-acquisition company.
To make the two companies comparable, it is recommended to use tangible book value which removes the effect of goodwill and other intangible assets (i.e.. subtract goodwill and intangible assets from stockholder’s equity).