(MONEY Magazine) – It's a great time to be a stock investor. The market, of course, has been booming. And you now have more financial information at your fingertips than ever before. There's more business coverage in the press and on television (just witness Maria Bartiromo's unstoppable rise to celebrity status). In addition, the availability of financial data on the World Wide Web--often instantly, at no or low cost--is the stuff investors' dreams are made of. You name it, we've got it: real-time stock quotes, online access to company filings with the Securities and Exchange Commission, computer programs that do everything from calculating basic financial ratios to charting a stock's price patterns over the past five years. What's more, with the rise of low-commission online trading, buying and selling is as easy as double-clicking.

Chances are, if you've been investing for any length of time, you've heard a lot of talk about price/earnings ratios and other tools the pros use to analyze stocks. To be an effective stock picker, you have to familiarize yourself with such yardsticks (see the box on page 80). But you also should know how to fit them into a conceptual model that steers you to stocks that meet your needs.

That's what this article will help you do. We'll go step by step through the selection process for the three main types of stocks--growth, value and income--and then use current data to bring the theory down to specifics. We'll discuss six stocks we identified this way--opportunities that we believe can return more than 11% compounded annually over the next five years. And we've also included three brief profiles of individual investors with no special training who have learned to pick great stocks on their own.

When analyzing stocks yourself, it makes sense to limit the field to big, widely followed companies. For one thing, you'll be able to get reliable information on them from free or inexpensive sources. Also, owning individual stocks is riskier than investing in mutual funds, and large, established stocks are far easier to research than small, obscure ones. For this story, we've focused on companies with annual sales of at least $3 billion.

We have also based our system on the most readily available data. You can get almost all the figures we use from a full-service broker, at any business library or over the Internet (see the box on page 84). Among the key sources: the Value Line Investment Survey and Standard & Poor's stock reports, which are available at most libraries.

To make the most efficient use of this information, you must begin by devising an orderly way to sift through large numbers of stocks. What you are looking for are stocks that have the best balance of characteristics such as earnings growth potential, financial stability and attractive valuation. So you want to start your stock picking by setting up a screen that will identify stocks with the specific attributes you favor. While you can screen companies by hand, computers have made this process easier--and faster. That's important because you often have to tweak the benchmarks you set to make sure that a manageable number of companies get through the screen. If only a dozen stocks pass, the criteria are probably too strict. If 100 pass, you've made the parameters too loose. Ideally, you want to end up with a manageable number of stocks--perhaps 40 or so--that you will winnow down with further research. We did our screening using Baseline, a service for institutions. You can do your screening with Microsoft Investor's Investment Finder (www.investor.msn.com), which costs $9.95 a month and requires Windows. Or you can use CD-ROMs from Morningstar, Standard & Poor's or Value Line, available at many public libraries. Less versatile software is available free at various Websites such as Quicken.com and Marketplayer.com.

As sharp as these tools may be, the final stage of the stock-decision process will always depend on qualitative factors and your own investing judgment. You might, for instance, prefer companies that have generally been successful over the past year or two. Or you might decide to favor industries that are currently depressed, such as energy and mining. Or you might want to consider the mix of industries represented in your existing portfolio, so the stocks you choose will help you diversify.

It's also important to acknowledge that the goal of this system is buying established, high-quality companies with widely recognized strengths at reasonable share prices. It's unrealistic to think that this approach will unearth hidden gems among microcaps or help you spot the next Internet rocket. That said, high-quality, fairly priced blue chips have historically delivered high, reliable returns.

Before we start screening, let's discuss the three building blocks of stock selection. First, you have to assess any potential investment's prospects for growth (or total return in the cases where yield plays a big part). Ultimately, the price of a stock will follow the growth in the company's profits, so you want to be as sure as you can about a company's ability to sustain or improve its earnings growth rate. Second, you have to evaluate any investment's riskiness, not only because you want to create a portfolio that's within your risk tolerance, but also because excessive risk detracts from the valuation a stock typically receives. The two most important types of risk to consider for stocks are volatility, usually measured by a figure called beta, and the potential for financial problems, usually gauged by looking at debt levels and capital on hand. Finally, you need standards for valuation that will enable you to figure whether a particular investment is overpriced or a screaming buy. To better illustrate these issues, we have created models to help find different types of stocks. You can follow our guidelines or tinker with them to create your own personalized approach.

PICKING GROWTH STOCKS

Growth stocks provide substantially all of their return in the form of price appreciation, which is driven by earnings growth. To beat the market's long-term average return of 10% to 12% a year, growth stocks need to be able to achieve earnings growth of more than 12% a year going forward. So in the growth-stock model, the first step is to run an earnings screen. We set up these requirements: earnings growth that topped 10% annually over the past five years and also 10% over the most recent 12-month period for which results are available. You can find these earnings data in Value Line Investment Survey or in the data packages that come with most screening programs, as well as on the Internet. We also suggest looking for projected growth of at least 12% this year and next. Finally, you want to be sure that each company has the financial muscle to meet its expansion goals. So we added another element to our screen, insisting that prospective buys have debt that's less than 35% of capital.

We recently applied these criteria to all companies with annual revenues of $3 billion or more, generating a preliminary group of 60 promising stocks. To trim this list, we considered a fact that is well established by numerous statistical studies: On average, companies with annual earnings growth in the 15%-to-22% range outperform those with 23%-plus growth. That's because moderate growers stand a better chance of hitting their targets year after year.

For that reason, we skipped over America Online and 17 other companies at the top of our screen that have current growth rates of 24% a year or more. These hot companies may be good investments, but they're inherently risky. Even a slight slowdown in their growth rates could undercut their high-flying stock prices.

The other stocks that passed our screen are hardly slackers. Some 28 have current growth rates in the 15%-to-22% range. We decided to focus on the ones that were the best known and had recently received positive media coverage--in other words, stocks that most active investors know something about. Among the stocks that survived to this stage: Sun Microsystems, Home Depot, Pfizer, Walgreen, United Technologies and Merck.

Some of these stocks had very high price/earnings ratios, and we decided to drop the ones with P/Es above 40. P/E is a good basic measure for stocks like these with moderately above-average growth rates in the 15%-to-22% range. The P/Es listed in newspaper stock tables are generally based on the most recent reported earnings, but most stocks actually trade on estimated future earnings. You can easily look up estimated 1999 results by clicking RESEARCH on the Yahoo! quote page or going to the Zacks Website. To calculate the so-called forward P/E, divide the current share price by estimated '99 results. Among the investor favorites on our list, Sun Microsystems, United Technologies and Merck had the lowest forward price/earnings ratios.

To make sure that their moderate P/Es weren't sounding a warning about a coming profit slowdown, we checked to see how the stocks were rated in Value Line and in Zacks' consensus analyst recommendations. Both Sun and United Technologies got good write-ups in Value Line. But we were discouraged by the fact that Merck has a lot of drugs coming off patent. We didn't feel we could assess the potential damage Merck might suffer from the loss of those drugs.

What did we learn about Sun and United Technologies? Here's a quick look at the factors that convinced us they were good choices (all the information can be found in Value Line, in recent news stories that are free on the Internet or in company press releases on the Net).

We liked the fact that Sun Microsystems recently launched Java 2, which runs much faster than the previous version of the Internet language. We figured that would help Sun continue to outperform the market (the shares have been on a real roll, up 100% in the past year). We also were impressed that Sun, along with America Online, is a part owner of Netscape. That relationship will likely encourage the wider adoption of the new version of Java. And Java's continued success should further stimulate sales of Sun's workstations--which account for most of its profits. Recently trading at $97.25 a share, the stock sports a 34.8 P/E, and a PEG ratio (P/E divided by projected growth rate) of 1.6. That's somewhat high but not unreasonable for such a dynamic growth stock. Sun's stock is volatile, with a beta of 1.4, meaning that the share price tends to swing 40% more than the S&P 500 index. We're willing to live with any temporary price swings, though, because the company's balance sheet looks rock solid. Sun has revenues of $11.3 billion, virtually no long-term debt and a hefty $1.4 billion in cash. No wonder it earns an A+ Financial Strength rating from Value Line.

We were drawn to United Technologies because of its aggressive business strategy of trimming low-margin businesses and bulking up high-margin ones. Some 30% of the company's $26.2 billion in annual revenues come from Pratt & Whitney aircraft engines, and United Technologies wants to add to those aerospace assets, which are currently depressed because of problems in Asia but potentially quite profitable. To that end, the company bid $4.3 billion in February for aerospace-components manufacturer Sunstrand. At the same time, United Technologies is trying to sell its automotive business. At $124.63 a share, 21.2 times estimated 1999 results, United Technologies is reasonably priced relative to its growth rate. With a beta of 1.1 and an A+ Financial Strength rating from Value Line, the stock isn't unduly risky either.

CHOOSING VALUE STOCKS

When it comes to value investing, you still need to look for solid financials and steady earnings growth. But more important, you need to identify stocks that are cheap by key value benchmarks, such as P/E or price-to-book value (the company's assets minus its liabilities). What you're hoping to do is buy into a solid company that is temporarily out of favor and enjoy double-barreled gains when other investors begin to see its true worth (earnings-driven price appreciation plus a higher P/E). That means you don't necessarily want to hold value investments indefinitely. Once the market has recognized them, they may no longer offer above-average returns.

P/E ratios are the natural place to start looking for value stocks. Once again we set up a model screen to illustrate the point. Our initial value screen included 5% annual earnings growth over the past five years and the past 12 months, projected annual growth of 7% for the next two years, debt of less than 35% of capital and a forward P/E below 22.

Forty-five stocks passed the screen, and to choose among them we decided to work down the list one by one, starting with the lowest P/E issues. Ideally, we were hoping to find companies that had projected growth of more than 12% a year, good ratings from Value Line and Zacks, and the lowest P/E we could get away with (ideally below 18). We also wanted to see a low price-to-cash-flow ratio. (Cash flow is generally defined as earnings plus depreciation and amortization; you can find reliable cash-flow estimates in Value Line). You can use P/CF ratios as a kind of tiebreaker when you are choosing from among a handful of stocks with low P/Es. We were also looking for some sort of catalyst that might lead investors to raise their valuations, so we favored stocks that had been in the news over the past year because of their restructuring efforts.

The stock that jumped out on the strength of its numbers alone was ITT Industries, one of the three companies created by the 1995 breakup of ITT (and also recommended in our January issue). The stock's P/E below 16 looks cheap enough, but the P/CF ratio below seven is stunning. The company has a solid 13% projected earnings growth rate. What confirmed those numbers was that ITT Industries is restructuring in ways likely to raise shareholder value. An example: The company sold its auto-parts business last year and has been using the $2.7 billion in after-tax proceeds to repurchase stock.

Allied Signal has less striking numbers, but solid ones nonetheless. AlliedSignal's earnings have grown at a 14% compound annual rate over the past five years as the company has wrung profits out of mundane businesses such as aerospace, turbines and chemicals. Earnings figure to rise 13% this year and next. With a 15.7 P/E based on estimated '99 results and a P/CF ratio of 12.1, the stock is fairly priced for that growth rate. In addition, the company's recent attempt to take over AMP showed that it is determined to enhance shareholder value. While that takeover failed, a friendlier acquisition could enable AlliedSignal to boost its growth rate and justify a higher P/E. With a 1.3 beta, the stock is volatile, but its stellar balance sheet earns an A++ Financial Strength rating from Value Line.

FINDING INCOME STOCKS

Income investments are the easiest to find by screening. Income stocks provide their return as a combination of earnings growth and dividends. You need the same sustainable growth that you'd look for with growth and value stocks, but you can afford to accept a much slower rate--if you're getting a fairly high, safe, dividend yield.

In our income-stock screen we began by looking for stocks with current yields above 3% that showed positive earnings growth over the past five years and at least 2% growth in the past 12 months. Then we looked for projected growth of at least 3% for this year and next. Nineteen stocks passed the screen. We started with those that offered the highest current yield and then worked down the list one by one. We decided to favor electric utilities because they tend to be predictable businesses. We also wanted price-to-cash-flow ratios below eight, and a projected total return (defined as earnings growth plus current yield) of close to 12% or more. The idea here is that over the long run income stocks will appreciate in line with their earnings growth, so your eventual return will reflect those capital gains plus the dividends you receive each year. When stocks were close, we favored the better-known one.

With the third stock on our list, we hit an investor favorite that met all the criteria: Southern Company. This electric utility serves Georgia, Alabama and several other states in the Deep South. Earnings growth is projected at up to 8% over the next two years, thanks to growing sunbelt demand for electricity. The company has also been actively positioning itself for deregulation by purchasing generating capacity in New York, New England and California. The power from these facilities will make Southern Company a major electricity marketer as deregulation proceeds. While its payout ratio (the percentage of its earnings devoted to dividends) is a bit above average at 75%, the stock carries an A Financial Strength rating from Value Line and currently yields 5.3%.

Further down the list we saw Nipsco Industries. This Indiana gas and electric company is acquiring Bay State Gas, which serves New England. Nipsco has an impressive record of 6% annual earnings growth, 7% annual dividend increases over the past five years and a very reassuring 60% payout ratio. Earnings gains over the next few years are projected at 7.5% or better. With an A Financial Strength rating from Value Line, Nipsco boasts a 3.9% current yield.

Of course, the more you learn about potential investments, the better. But screens like the ones we've discussed always make a good starting point--whether you're choosing all your own stocks, working with a broker or simply want to understand the holdings of your mutual funds. And used wisely, our method can lead you to the kind of solid stocks that should be the foundation of everyone's portfolio.