Due diligence (DD) refers to researching a company (or company stock) before investing.
This post will review some of the first things you should do when evaluating a new stock. You may learn crucial details and rule out a risky new purchase by carrying out this due diligence.
What does “DD” Mean?
“Due diligence” is abbreviated to “DD.”
Conducting due diligence on a prospective investment is essential. It involves a deeper dive into a stock’s fundamentals, financial performance, valuation, and market sentiment. Due diligence is analogous to obtaining a house inspection. A home inspection is a necessary step before purchasing a house.
The same applies to investing: you need to know the company’s strengths and limitations before acquiring its shares. Stocks of all sizes and values, from blue chips to penny stocks, benefit from due diligence. Investments, in general, benefit from doing so.
Types of Due Diligence
You may classify due diligence as “hard” or “soft,” depending on the approach used.
Hard Due Diligence – “hard due diligence” refers to the extensive research and study of a company’s financial and operational performance, management team, and legal compliance. Consideration of the company’s competitors and the state of the industry as a whole is also part of this analysis.
Financial statements, revenue growth patterns, cost structure, debt levels, intellectual property, customer contracts, regulatory compliance, litigation history, and management succession planning may be evaluated during complex due diligence.
Soft Due Diligence – Investors perform soft due diligence when they look into a firm to see its morals and values. Diversity and inclusion practices, worker rights, environmental effects, and corporate governance regulations are topics that need to be investigated.
Soft due diligence is a valuable tool for checking whether an investment aligns with one’s ideals and whether or not it backs ethical business practices. These facts about a firm may be obtained through public sources and direct communication with management, but they lack the rigor of a complex due diligence investigation.
Compared to complex due diligence, which provides more certainty, this method may be sufficient for less substantial investments or shorter-term transactions.
How to Perform Due Diligence for Stocks
Before buying shares, you should always do your homework on a firm or company. Take a look at this due diligence checklist before making any purchases.
Verify the company’s market capitalization.
The overall worth of a firm is measured by its “market capitalization” (often abbreviated “market cap”). The formula is the share price multiplied by the total number of shares. A firm’s market capitalization may also be seen via a stock broker or on an online financial portal like Yahoo Finance.
Reasons why market capitalization is essential:
- Evidence of the company’s massive size.
- It demonstrates the vastness of the company’s influence
- Larger firms often have less revenue volatility and more stable earnings than smaller firms.
- Smaller firms are more prone to volatility but could offer more potential rewards.
Analyze Revenue and Margin Trends
An organization’s profit margin is the proportion of its retained revenue as net income. Revenue measures how much money an organization is taking in.
The present state of affairs in terms of income and profit and the long-term patterns for the preceding years should be examined. Earnings reports from companies often include this kind of data.
We need to keep an eye on revenue and profit margins because:
- They demonstrate the firm’s reliability throughout the years.
- As such, they reveal whether the business is expanding, contracting, or maintaining its current activity level.
- These numbers reveal whether or not a business is making money.
- Value indicators such as the price-to-sales ratio and the price-to-earnings ratio rely on these figures.
Review Industries and Competitors
Now that you know the firm’s size and revenue, you can evaluate the markets it serves and the companies it competes with. Examine the profit margins of at least three similar businesses. Competitors have a significant role in shaping the identity of any business.
The size of the end markets for a company’s goods may sometimes be inferred by analyzing the market share held by the company’s top rivals in each of the company’s business lines.
Most extensive stock research sites will have details about the company’s rivals. When investigating a firm, you can often locate its rivals’ ticker symbols and side-by-side comparisons of specific indicators. Reading about the activities of rival companies may often provide light on the nature of your target company.
Examine Valuation Indicators
A company’s valuation measures how well its market worth corresponds to its profitability. An undervalued, overpriced, or appropriately valued firm valuation is crucial information for investors. It also facilitates the examination of the values of businesses in the same industry.
Valuation may be analyzed from many perspectives. Standard procedures, together with their abbreviations:
Price-to-earnings ratio (P/E) – Divide the share price by the earnings per share to get the price-to-earnings ratio (P/E). It’s a helpful tool for comparing successful businesses.
Price-to-sales ratio (P/S) – The price-to-sales ratio (P/S) is determined by dividing the current share price by the per-share sales revenue of the firm (usually prior 12-month sales or future 12-month sales projections). It prioritizes sales numbers above bottom-line figures.
Price-to-earnings growth ratio (PEG) – This is determined by dividing the P/E ratio by the earnings growth rate of the firm over a specific period. Comparing firms with similar growth rates may be facilitated by looking at their P/E ratios.
Price-to-book ratio (P/B) – The price-to-book ratio (P/B) is determined by comparing a company’s market capitalization to its book value (book value is the net assets of the company, taken from the balance sheet). The insurance, banking, and real estate industries often use this method.
Review Management and Ownership
You should know the answers to critical questions about the company’s management and ownership as part of your stock due diligence. Do original leaders run the company? Or have there been significant changes to the leadership and board?
Compared to older companies, significantly more of the original employees of newer organizations will likely be working there now. The breadth of expertise of top managers may be gauged by reviewing their combined bios. This data is published in SEC filings and on the company’s website.
Examining the company’s ownership structure, including the percentage of shares held by company insiders, might be instructive. In some ways, it’s a positive indicator if the company’s top brass owns a large percentage of its shares. It may be a warning sign if they try quickly unloading their investments.
Assess the Financial Health
Analysis of the company’s financial statements is crucial. Both the company’s assets and debts may be seen here. You should also consider cash flow, net income, and other sources of revenue in addition to the balance sheet.
Where do the majority of the company’s funds come from? Does net income amount to a positive or negative number? Can you see any patterns?
The company’s financial statements will be posted online, generally in the site’s “investor relations” area.
Review the Stock Price History
It is essential to know how long each share class has been trading and how much the price has fluctuated over the short and long terms. Has the stock price been very volatile, or has it been somewhat stable?
This lays out the typical profit experience of stockholders, which might affect the direction of the stock. The high turnover of short-term holders in stocks with a history of extreme volatility could put off investors who aren’t willing to take the long view.
Examine Stock Options and Dilution
Then, look at the 10-Q and 10-K forms. To comply with SEC regulations, companies must report outstanding stock options and their expected value upon conversion at various future stock levels in quarterly reports.
Use this to learn how the number of outstanding shares could shift in response to a change in the stock price. Keep an eye out for suspicious actions, such as re-issuing “underwater” options or official inquiries into unlawful methods like options backdating, even if stock options may be a strong incentive for keeping staff.
Analyze Market Predictions
Speculations about the company’s future are based on the opinions of industry experts. What are the anticipated profits, and how much money will be made for each share? What do Wall Street experts predict the stock price will do in the future? How do people feel about it in financial publications and online forums?
This additional research is part of the due diligence process and serves as a “catch-all.” The impending release of a new product or service might have piqued your interest in the stock. It would be best to look at it now using your gathered information.
Consider Risks and Weaknesses
Keeping this crucial information until last ensures that the hazards associated with investing are always emphasized. Learn about the dangers facing your industry and your firm. What, if any, legal or regulatory issues remain unresolved?
Is the company’s management taking actions that boost revenue? How concerned is the firm with environmental issues?
What potential consequences will its green initiative adoption have in the long run? Investors should always have a devil’s advocate mentality when considering a stock’s performance and prepare for the worst.
Why Due Diligence is Important
To assist you in preventing fraud and poor investments, due diligence is crucial. If they complete their research, investors may be sure they are making a good trading selection.
Conducting due diligence will protect your portfolio against expensive blunders and guarantee its diversification.
For instance, having a mix of high-risk and low-risk stocks in your portfolio is prudent when investing in the stock market. Your earnings will be more secure if the market ever drops. A well-balanced portfolio includes large, well-established corporations and smaller, up-and-coming ones or stock options.
When markets are unpredictable, it is crucial to have a portion of your portfolio invested in low-risk securities. You may cushion the blow of the market’s ups and downs by putting your money into dependable firms on which you’ve performed your due diligence.
Final Thoughts on Due Diligence
When you’ve finished your due diligence, you’ll have a good idea of the company’s profit potential and whether or not the stock makes sense for your portfolio. There may inevitably be particulars that need more investigation on your part.
Nonetheless, if you stick to these rules, you won’t have to worry about overlooking information that might be crucial to your judgment.