So, what is due diligence? It is generally understood as a process of audition or investigating in order to confirm certain facts or information. For the financial sector, in particular, due diligence is defined as an examination of financial records after which an entity or an individual can enter into a transaction with someone else. Systematic due diligence helps analyze and mitigate risks while making investment and business decisions.
Due diligence has been a common practice in finance starting from the moment when the Securities Act of 1933 was passed in the USA. The law obliged securities traders and brokers to fully disclose information about the instruments they were trading. Otherwise, they would be criminally prosecuted.
The lawmakers soon realized that such a requirement makes brokers and dealers prosecuted unfairly sometimes since some material facts could be not known to them at the moment of sale. Resultingly, the new requirement was to exercise “due diligence” while examining the companies whose equities went in sale. The traders and brokers were then required to disclose the information fully and thus were not responsible for information that did not come up during the investigation process.
Due diligence types
Many actors on the financial market can perform due diligence: individual investors, equity research analysts, broker-dealers, fund managers, companies planning to acquire other companies. When it comes to individual investors, due diligence is basically voluntary for them. Yet for broker-dealers, it is a legal obligation: conducting due diligence on securities that they are seeking to sell.
Due diligence check-list
Mostly these following steps are applied while investigating stocks but are also often used in relation to real estate, bonds, and many other investment types. For checking off all the stages it is necessary to have access to the company’s quarterly and annual reports as well as have available the company profiles on discount brokerage sites and financial news.
- The company’s capitalization
The total value of a company, in other words, its market capitalization, shows where its stock price is volatile, whether its ownership is broad, what is the size of its potential target markets. It is typical for large-cap and mega-cap firms to demonstrate stable revenues and a wide investor base. While mid-cap and small-cap companies tend to have higher volatility rates in stocks and earnings.
- Profit, revenue, margin
It is key to monitor these trends from the company’s income statement over time. It is especially worthful to pay attention to return on equity, profit margins, operating expenses, revenue.
- Industries and competition
After determining the size of the company and the level of its earning, it is useful to compare it to other companies in the industry. To fulfill the due diligence plan, we need to compare the company’s profit margins to at least two or three of its competitors. This step will help the understanding of whether the given industry is growing or if the company has a leading position.
- Valuation multiples
While there are numerous financial metrics for evaluating companies, it is practical to focus on these in particular: the price to earnings (P/E) ratio, the price/earnings to growth (PEGs) ratio, and the price to sales (P/S) ratio. It is possible to search for these values on the internet, and while doing so it would not harm to compare them to the values of a couple of competitors, too.
- Management and share ownership
By performing this step we can learn if the company is still led by its founders or by the new board. After researching who runs the firm, let’s find out the level of experience and expertise of the people leading the company. It is also important to check the ratio of shares held by founders and executives. Usually, if it is low and the top managers have been selling shares recently, it is a bad warning.
- Balance sheet
Using the balance sheet of a company we can check its level of debt. It is necessary to compare it to others in the industry and generally take into account what industry we are dealing with. The reason is that some companies and industries are capital intensive. In this case, debt is not necessarily a bad thing, still, it is necessary to evaluate whether the debts are highly rated by the rating industries.
- History of stock prices
While conducting due diligence, investors should take a look at both short-term and long-term price shifts in stock and how volatile those shifts are. Doing this, it is important to keep in mind that previous history of movements does not guarantee the same pattern in the future, yet helps to see the bigger picture about the company.
- Stock dilution possibilities
Before making any investment decisions, it is useful to know how many shares outstanding the company has and what is the number of its competitors as well as to find out if the company will be issuing any more shares.
The estimates’ consensus of Wall Street analysts for earnings growth, revenue, and profit for the next couple of years truly comes in handy. In addition, it is a good call to examine the long-term trends in the industry, news about joint ventures, new products, or intellectual property.
- Short and long-term risks
Examining the possible risks is crucial for investment plans. Due diligence process is required to take a rather negative look and imagine the worst-case-scenario situations and their influence on the company’s stock.
Does due diligence still seem a bit complicated to you? No worries, COREDO provides many due diligence services and advice.