One of the questions I get most often as an analyst is, How do you find the stocks you recommend? There are actually a number of ways to generate ideas, but one of the best and most replicable for investors at home is screening. This means asking a computer to look for companies that fit several predetermined and desirable criteria.

The difficult part of screening, of course, is knowing what to ask the computer to look for. To help you out in that regard, I thought I’d share with you today one of the screens I use to find great micro-cap stocks for our Motley Fool Hidden Gems research service. As an aside, I’ll just note that micro caps are among the most exciting segments in the stock market today. While it’s definitely volatile, you won’t find any other slice of the market that matches its potential upside.

Step 1: Identify a micro cap

The first thing one needs to do when looking for great micro caps is to start with small companies. For our purposes, that means any company with a market cap less than $250 million.

According to my screen, there are 2,433 companies trading on the major U.S. exchanges for less than $250 million. That’s too many to be helpful, which means we need additional criteria.

Step 2: Identify a strong business

While there are any number of ways to identify a strong business, when it comes to micro caps, a strong balance sheet is one of the most important traits a company can have. That’s because small companies don’t have a lot of room for error, and cash is a safety net when the economy turns south.

From there, I also like to see a micro cap that’s already free cash flow-positive. This generally indicates that the company has already figured out a sustainable business plan — not a given for very small companies.

According to my screen, there are 381 micro caps with more cash than debt and positive free cash flow. That’s still a few too many to be helpful, which means we need additional criteria.

Step 3: Identify a good value

Again, there are many ways to get after valuation, but there a few thumbnail measures — such as Price-to-Earnings and Price-to-Book — can be helpful in screening. I like to use Enterprise Value-to-EBITDA, which takes into account the state of a company’s balance sheet, but omits charges that are not core to operations. Generally speaking, anything less than seven here gets our attention.

There are 146 micro caps trading for less than seven times EBITDA. That’s still too many to be helpful, which means we need additional criteria.

Step 4: Identify a shareholder-friendly firm

This can be a difficult quality to screen for, but two proxies we use are insider ownership and whether or not a company pays a dividend. If a micro cap is significantly owned by its managers, and pays a dividend to shareholders, the company’s interests are more likely aligned with those of outside investors.

By looking again for micro caps with better than 10% insider ownership and regular dividend payments, the screen returns with 27 names — a manageable number to look over.

Our candidates

After glancing at each of the 27 promising candidates, here are 7 that caught my attention: