Fundamental Screening

Fundamental Screening

Fundamental screening is a method used by investors and traders to identify potential investment opportunities by analyzing the financial health and prospects of companies. It involves evaluating economic and financial factors to determine the intrinsic value of a stock or other asset, and then comparing that value to its current market price. This article will provide a comprehensive overview of fundamental screening, geared towards beginners, covering its principles, key metrics, common strategies, tools, and limitations. It will also explore how fundamental screening complements other forms of analysis, such as Technical Analysis.

What is Fundamental Screening?

At its core, fundamental screening is about understanding *what* a company does and *how well* it does it. Unlike Technical Analysis, which focuses on price charts and trading volume, fundamental analysis delves into the underlying factors driving a company’s performance. These factors can be broadly categorized as:

**Macroeconomic Factors:** These are large-scale economic conditions that affect all companies, such as interest rates, inflation, GDP growth, unemployment rates, and government policies. For example, rising interest rates can negatively impact companies with significant debt.
**Industry Factors:** These are conditions specific to the industry a company operates in. Factors like competition, regulatory changes, technological advancements, and consumer trends all play a role. A disruptive technology could threaten established players in an industry.
**Company-Specific Factors:** These are unique characteristics of the company itself, including its financial statements, management team, competitive advantages, and future growth prospects. This is the primary focus of fundamental screening.

The goal of fundamental screening is to identify undervalued companies – those trading at a price below their intrinsic value – or to find companies with strong growth potential. Investors believe that the market will eventually recognize the true value of these companies, leading to price appreciation.

Key Financial Metrics for Fundamental Screening

Numerous financial metrics are used in fundamental screening. Here’s a breakdown of some of the most important ones, categorized for clarity:

1. Profitability Ratios

These ratios measure a company’s ability to generate profits from its revenues.

**Gross Profit Margin:** ((Revenue - Cost of Goods Sold) / Revenue) x 100. Indicates how efficiently a company produces its goods or services. Higher is generally better. Consider comparing to industry averages. Value Investing often prioritizes companies with high gross profit margins.
**Operating Profit Margin:** (Operating Income / Revenue) x 100. Shows the profitability of a company’s core operations. A good indicator of operational efficiency.
**Net Profit Margin:** (Net Income / Revenue) x 100. Represents the percentage of revenue that translates into profit after all expenses, including taxes and interest, are deducted.
**Return on Equity (ROE):** (Net Income / Shareholder’s Equity) x 100. Measures how effectively a company is using shareholder investments to generate profits. A higher ROE is generally desirable. See also DuPont Analysis.
**Return on Assets (ROA):** (Net Income / Total Assets) x 100. Indicates how efficiently a company is using its assets to generate profits.

2. Liquidity Ratios

These ratios gauge a company’s ability to meet its short-term obligations.

**Current Ratio:** Current Assets / Current Liabilities. Indicates a company’s ability to pay off its short-term debts with its short-term assets. A ratio of 1.5 to 2 is generally considered healthy.
**Quick Ratio (Acid-Test Ratio):** (Current Assets - Inventory) / Current Liabilities. A more conservative measure of liquidity, excluding inventory, which may not be easily converted to cash.
**Cash Ratio:** (Cash + Marketable Securities) / Current Liabilities. The most conservative liquidity ratio, focusing on readily available cash and equivalents.

3. Solvency Ratios

These ratios assess a company’s ability to meet its long-term obligations.

**Debt-to-Equity Ratio:** Total Debt / Shareholder’s Equity. Indicates the proportion of debt a company uses to finance its assets relative to equity. A lower ratio is generally preferred, but varies by industry.
**Debt-to-Asset Ratio:** Total Debt / Total Assets. Measures the percentage of a company’s assets that are financed by debt.
**Interest Coverage Ratio:** Earnings Before Interest and Taxes (EBIT) / Interest Expense. Shows a company’s ability to pay its interest expense. A higher ratio is better.

4. Valuation Ratios

These ratios help determine if a stock is overvalued or undervalued.

**Price-to-Earnings (P/E) Ratio:** Stock Price / Earnings Per Share (EPS). Indicates how much investors are willing to pay for each dollar of a company’s earnings. Lower P/E ratios may suggest undervaluation, but must be considered in context. Benjamin Graham heavily relied on P/E ratios.
**Price-to-Sales (P/S) Ratio:** Stock Price / Revenue Per Share. Useful for evaluating companies with negative earnings.
**Price-to-Book (P/B) Ratio:** Stock Price / Book Value Per Share. Compares a company’s market value to its book value (net asset value). Can identify potentially undervalued companies.
**PEG Ratio:** (P/E Ratio) / Earnings Growth Rate. Takes into account a company’s expected earnings growth. A PEG ratio of 1 is generally considered fairly valued.
**Dividend Yield:** Annual Dividend Per Share / Stock Price. Represents the percentage of a stock's price that is returned to shareholders as dividends.

5. Growth Metrics

**Revenue Growth Rate:** ((Current Revenue - Previous Revenue) / Previous Revenue) x 100. Indicates how quickly a company is growing its sales.
**Earnings Per Share (EPS) Growth Rate:** ((Current EPS - Previous EPS) / Previous EPS) x 100. Shows the rate at which a company’s earnings are growing.
**Return on Invested Capital (ROIC):** Net Operating Profit After Tax / Invested Capital. Measures how effectively a company is generating returns from the capital it has invested.