Screening for Potential Equity Investments

Financial ratios are oftentimes used to screen potential equity investments by identifying companies that meet specific criteria. This analysis may be used in the creation of a portfolio. Alternatively, it may form part of a more thorough analysis of potential investment targets.

Fundamental decisions must be made in regard to the metrics to use as screens, the number of metrics to include, the value of the metrics to use as cut-off points, and the weighting that each metric should be given.

The Use of Financial Analysis in Screening Potential Equity Investments

A simple stock screen may include the following criteria:

• a valuation ratio, for example, the P/E ratio, which is less than a specified value;
• a solvency ratio, for example, total debt/assets, which does not exceed a specified value;
• positive net income; and
• the dividend yield is greater than a specified value.

These criteria are often not independent. Some criteria will serve as checks on the results obtained from applying other criteria. Additionally, the results of stock screens can sometimes be relatively concentrated in a subset of the sectors that are represented in the benchmark.

Although they are most common among value investors, stock screens can be used by growth investors, value investors, and market-oriented investors. Growth screens typically feature criteria related to earnings growth and/or momentum. Value screens usually feature criteria that set upper limits for the value of one or more valuation ratios. Market-oriented screens do not strongly emphasize valuation or growth criteria.

Back-testing can be useful in the evaluation of how a portfolio based on a screen would have performed historically. It applies the portfolio selection rules to historical data and computes what returns would have been earned if a particular strategy had been used. Its relevance to investment success may be limited due to the following limitations:

• survivorship bias: if the back-testing database eliminates companies that cease to exist, the remaining companies collectively will appear to have performed better;
• look-ahead bias: if restated financial data is included in a database, there will be a mismatch between what investors would have known at the time they invested and the information used in the back-testing; and
• data-snooping bias: this can occur when a model is built based on previous findings, and then the same database is used to test the model.

Question 1

Which of the following statements is the least accurate?

1. The criteria used in stock screens are often independent.
2. Value screens usually feature criteria that set upper limits for the value of one or more valuation ratios.
3. Back-testing may not provide a reliable indication of future stock performance because of survivorship bias, look-ahead bias, or data-snooping bias.

Solution

The correct answer is A.

The criteria used in stock screens are often not independent.

Options B and C are accurate statements.

Question 2

Which of following criteria should an analyst include when screening potential equity investments based on return on equity?

1. Positive net income.
2. Negative shareholders’ equity.
3. Negative cash flow from operations.

Solution

The correct answer is A.

Requiring that net income be positive would eliminate companies that report a positive return on equity only because both net income and shareholders’ equity are negative.

This makes options A accurate and option B inaccurate.

C is incorrect. Negative cash flow from operations would most likely indicate that the analyst should probably not invest in the company.