Notes

Module: V Lecture:19

Stock Screeners

What is a Stock Screener?

 With this, you would now be in a position to apply the principles of value investing for
your own stock portfolio.

 At this point, you may have a question: How to get started?

 There are two broad approaches to fundamental investing - top-down approach and
bottom-up approach.

 The top-down approach lays greater emphasis on the macro factors.

 An investor would first evaluate the macro economy.

 Based on the analysis of macro trends, he would pick up a sector or sectors that would
be likely beneficiaries.

 And then from within those sectors, an investor would pick up fundamentally-sound
companies.

The Bottom-Up Approach

 While the top-down approach is logically sound, it depends on certain macroeconomic

 On the other hand, the bottom-up approach has a more company-specific

 An investor’s investment decision would be primarily based on the individual merits and
demerits of a stock.

 Some of the most successful value investors including Mr Buffett have followed this
investment approach.

 This, however, does not mean that one should ignore the larger sectoral and macro
trends. The idea is to be wary of risks from top-down perspective but invest bottom up.
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Module: V Lecture:19

The Need for a Stock Screener

 If an investor were to follow the bottom-up approach, how should he go about selecting
companies that he would like to research on?
 There are more than 5,000 companies listed on the BSE.
 It is humanly impossible to peruse through the business and financials of every
company.
 To remedy this, one can take the help of stock screeners.
 Stock screeners are financial and valuation filters that can help you zero down
on companies that could be prospective investment candidates.
 This can be useful to eliminate all the companies that don’t fit the prerequisite financial
criteria.

Types of Stock Screener

 The next question is: How do you choose the right stock screener?

 Ideally, the choice of the screener must reflect your investment philosophy.

 The various parameters that you use in a stock screener are business and performance
attributes that you expect a prospective stock to possess.

 You can create your own stock screener based on factors that you believe are critical in a
sound business.

 In the coming slides, we will discuss some important stock screeners based on the
principles of some noteworthy value investors.

Benjamin Graham Stock Screeners

 Benjamin Graham, known as the ‘Father of Value Investing’, largely focused his stock
picking approach on finding deep bargains.

 During his earlier years, his investment strategy was to buy stocks that were available at
a price below their net current asset value.

 This methodology produced very good results.

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Module: V Lecture:19

 However, after the long bull-run commenced in 1949 such bargain opportunities
became increasingly rare.

 In 1973, just three years before he passed away, he presented an elaborate study which
showed that in every two-year period between 1958 and 1971, stocks had
either risen or fallen by at least 33%.

 This finding encouraged him to find a quantitative framework that would be able to take
advantage of such volatility in the stock markets.

 As per Graham, such a quantitative system would have to be logical, easy to

 Which financial criteria would be able to fulfill all three conditions across time periods?

 Based on the principles and criteria laid down by Graham, we will discuss three stock
screeners that could help you pick value stocks trading at a steep discount.

Benjamin Graham - Stock Screener #1

 The first stock screener has two parameters- Price to Book Value ratio and Debt to
Equity ratio.
 The conditions are as follows:
1) Stock price must be less than two-third the book value per share;
2) Debt to Equity ratio less than 1.
 Please note that in addition to the above conditions, P/BV ratio must be greater than
zero and D/E ratio must be greater than or equal to zero.
 This will ensure that you eliminate companies with negative net worth.
 As you saw, the first parameter in this stock screener is Price to Book Value ratio.
 This ratio shows the relationship between the stock price and the balance sheet.
 Book Value is what remains for the equity holders if the company were to go for
liquidation (Total Assets - Total Liabilities).
 Book Value = Net Worth = Shareholder’s Funds
 By setting a condition to screen stocks that are trading at less than two-third their book
value, you would get stocks that are trading at a deep discount to their net worth.
 The Debt to Equity condition ensures that you avoid highly leveraged companies.

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Module: V Lecture:19

Benjamin Graham - Stock Screener #2

 The second stock screener has two parameters: Price to Dividend Yield ratio and Debt to
Equity ratio.

 The conditions are as follows:

1) Dividend yield must be at least two-thirds of the bond yield or greater;

2) Debt to Equity ratio less than 1 (and greater than or equal to zero as mentioned
previously).

 Dividend yield is a financial parameter that shows the returns earned on a stock
investment from dividends.

 Dividend yield = Dividend per share / Stock price

 Say you bought stock X at Rs 100 per share with dividend per share of Rs 8, the
dividend yield on the stock is said to be 8%.

 Why is dividend yield important?

 Dividend yield ensures that investors earn a return on their investment even in the
absence of stock price appreciation.

 It provides a steady stream of income for long term investors without them having to
sell their stocks.

 Going back to the screener, the first condition said that the dividend yield of a stock
must be at least two-third of the bond yield or greater.

 The corporate bond yield in India is close to 10%.

 So assuming a bond yield of 10%, the dividend yield must be 6.7% or

Benjamin Graham - Stock Screener #3

 The third stock screener has two parameters: Earnings to Price ratio and Debt to Equity
ratio.

 The conditions are as follows:

1) Earnings to Price ratio must be at least twice the bond yield;

2) Debt to Equity ratio less than 1 (and greater than or equal to zero).
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Module: V Lecture:19

 Earnings to Price ratio (also known as Earnings Yield) is nothing but the inverse of Price
to Earnings ratio.

 The first condition of the screener said that the Earnings to Price ratio must be at least
twice the bond yield.

 So if the bond yield is 10%, the earnings yield must be at least 20%.

 A 20% earning yield means that if the stock price is 100, earnings per share is 20.

 Taking an inverse of the Earnings to Price ratio, you get a Price to Earnings multiple of
5x (100/20).

 Hence, you could rephrase the first condition as Price to Earnings ratio of 5 or
less.

Warren Buffett Stock Screener

 Benjamin Graham’s most astute student Warren Buffett kept the principles of value
investing taught by his mentor intact.

 However, he redefined his approach to focus more on quality.

 He focuses on companies that have a very durable economic moat and are
trading at ‘fair’ valuations.

 This is in contrast with his mentor’s focus on deep discount stocks without much
emphasis on a firm’s qualitative factors.

 Let us try and understand the typical qualities of a stock that Warren Buffett would buy
and how an investor could create a screener to find such companies.

 We have identified some key parameters that can help you zero down on stocks that
possess the attributes that a typical Warren Buffett stock is likely to possess:

 High return on equity

 Strong Dividend payout ratio

 Low debt to equity ratio

 Fair price to earnings ratio

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Module: V Lecture:19

Magic Formula Stock Screener

 We just went through a stock screener that was derived on the basis of Warren Buffett’s
value investing principles.

 However, it must be noted that it was just one of the various ways of finding a
quantitative interpretation of Buffett’s stock picking approach.

 We will now go through Joel Greenblatt’s Magic Formula stock screener.

 In his stock screener, Greenblatt has tried to arrive at a quantitative translation of

 As you can see, there are two key factors in Buffett’s approach - Great business and fair
price.

 How can these qualitative factors be defined in quantitative terms?

 Greenblatt uses the following algorithm to arrive at a financial metric that would be an
approximate translation of the two qualitative terms.

1) Great business: As per Buffett, a great business is one that earns a high return on
capital (ROC).

 Now, there are various ways to look at a company’s ROC.

 Let us see how Greenblatt defines the ROC…

 Return on Capital = Earnings Before Interest & Tax (EBIT) / Capital

 As per Greenblatt, Capital = Net Plant, Property and Equipment + Net Working Capital

 It is noteworthy that he has excluded excess cash and interest-bearing assets.

 In other words, he has included only those assets in his definition of ‘Capital’ that are
actually used in the business to generate a return.

 Fair price: Buffett prefers a great business at a fair price than a fair business at a
bargain price.

 Let us see how Greenblatt defines the financial parameter that would determine a
company’s fair price.

 For this second factor, he uses ‘earnings yield’. As we have noted earlier, earnings
yield is nothing but the inverse of price to earnings ratio.

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Module: V Lecture:19

 However, Greenblatt differs in his approach in that he uses EBIT instead of net profit in
the numerator and Total Enterprise Value (TEV) instead of just market capitalisation in
the denominator.

 As per Greenblatt’s equation,

Earnings Yield = EBIT/TEV

 Let us understand what Total Enterprise Value is and why Greenblatt chooses to
compare EBIT/TEV instead of P/E.

 Total Enterprise Value is the cost an acquirer would have to pay to buy out the entire
company.

TEV = Market Cap. + Total Debt - Cash & Cash Equivalents + Minority
Interest + Preferred stock

 The reason Greenblatt uses EBIT/TEV instead of P/E is to facilitate a like-for-like

 When you use the P/E ratio, you compare a company’s net profits to its market
capitalization.

 However, market capitalization does not provide you any clue about a
company’s capital structure and how it finances its business.

 This would make it difficult to compare debt-fee and debt-laden companies.

 On the contrary, when you use Greenblatt’s formula, you’re comparing EBIT with the
entire value of the company.

 So when you’re comparing the valuations of a large number of companies using a

 So as we discussed, Greenblatt’s Magic Formula has two metrics:

1) Return on Capital (EBIT/ [Net Fixed Assets + Net Current Assets])

2) Earnings Yield (EBIT/ TEV)

 You run these two metrics on all the companies in your set.

 Arrange the companies in the descending order of their ROC. Assign the rank 1 to the
company with the highest ROC and go on assigning ranks in that order.

 Carry out the same process for Earnings Yield.

 Once you have all the companies with two respective ranks, then next step is to do a
combined ranking.
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Module: V Lecture:19

 Greenblatt assigns equal weightage to both ROC and Earnings Yield. Hence, you simply
have to do the summation of the two ranks to arrive at the combined rank.

 As per Greenblatt, the lower the combined ranking, the better the stock.

(Kindly view Excel titled ‘VI19 - Stock Screeners)

Things to Keep In Mind

 While stock screeners are great stock picking tools, there are some things that investors
must bear in mind.

1) Stock screeners are statistical tools. They may not always be reliable indicators
a company’s quality and intrinsic value.

2) Stock screeners indicate a company’s past performance. They provide no

3) The results of a stock screener must not be taken at face value. Investors can take
the results as a starting point for further research and analysis.

Conclusion

 Stock screeners are excellent tools to scan the entire universe of stocks and to find
stocks that possess the attributes that you are looking for.

 They are effective tools to filter away undesirable stocks.

 In the lecture so far, we discussed 5 different stock screeners based on the

 If used diligently stock screeners can yield great results.

 In the next module on Behavioral Finance, we will discuss the psychological aspects
of investing and how investors can minimize biases and thinking errors from their
investment decision-making process.

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Module: V Lecture:19

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