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Understanding Due Diligence

Due diligence became common practice (and a common term) in the U.S. with the passage of the Securities Act of 1933. Securities dealers and brokers became responsible for fully disclosing material information related to the instruments they were selling. Failing to disclose this information to potential investors made dealers and brokers liable for criminal prosecution. However, creators of the Act understood that requiring full disclosure left the securities dealers and brokers vulnerable to unfair prosecution if they did not disclose a material fact they did not possess or could not have known at the time of sale. As a means of protecting them, the Act included a legal defense that stated that as long as the dealers and brokers exercised “due diligence” when investigating companies whose equities they were selling, and fully disclosed their results to investors, they would not be held liable for information not discovered during the investigation.

Types of Due Diligence

Due diligence is performed by companies seeking to make acquisitions, by equity research analysts, by fund managers, broker-dealers, and investors. The due diligence on a security by investors is voluntary. However, broker-dealers are legally obligated to conduct due diligence on a security before selling it, which helps to prevent any issues arising with non-disclosure of pertinent information.

A standard part of an initial public offering is the due diligence meeting, a process of careful investigation by an underwriter to ensure that all material information pertinent to the security issue has been disclosed to prospective investors. Before issuing a final prospectus, the underwriter, issuer and other individuals involved (such as accountants, syndicate members, and attorneys), will gather to discuss whether the underwriter and issuer have exercised due diligence toward state and federal securities laws.

The Due Diligence Process for Stock Investing

Below are detailed steps for individual investors undertaking due diligence. Most are related to equities, but aspects of these considerations can apply to debt instruments, real estate, and other investments as well.

The list below of due diligence steps is not comprehensive since there are many types of securities in existence and as a result, many variations of due diligence that might be needed for a specific investment.

Also, it’s important to consider risk tolerance when performing due diligence. There’s no one-size-fits-all strategy for investors since investors might have different risk tolerance levels and investment goals. Retirees, for example, might look to an investment for dividend income and might place a higher value on more established companies while an investor seeking growth might place a higher value on capital investment and revenue growth. In other words, due diligence can result in different interpretations of the findings depending on who’s performing the research.

Step 1: Analyze the Capitalization (Total Value) of the Company 

A company’s market capitalization can provide an indication of how volatile the stock price might be, how broad the ownership might be, and the potential size of the company’s target markets.

For example, large-cap and mega-cap companies tend to have stable revenue streams and a large, diverse investor base, which can lead to less volatility. Mid-cap and small-cap companies, meanwhile, may only serve single areas of the market and typically have greater fluctuations in their stock price and earnings than large corporations.

The size and location of the company might also determine which exchange the stock is listed on or where it trades. You should also confirm whether the stock is listed on the New York Stock Exchange, Nasdaq, or if it’s an American depositary receipt (ADRs), which means it’ll have another listing on an exchange in another country. ADRs will typically have the letters “ADR” written in the title of the share listing.

Step 2: Revenue, Profit, and Margin Trends

In analyzing the numbers, the income statement will have the company’s revenue or the top line, net income or profit, which is called the bottom line. It’s important to monitor any trends in a company’s revenue, operating expenses, profit margins, and return on equity.

Profit margin is calculated by dividing the company’s net income by revenue. It’s best to analyze profit margin over several quarters or years and compare those results to companies within the same industry to gain perspective.

Step 3: Competitors and Industries

Now that you have a feel for how big the company is and how much money it earns, it’s time to size up the industries it operates in and its competition. Every company is partially defined by its competition. As stated earlier, compare the profit margins of two or three competitors. Looking at the major competitors in each line of business (if there is more than one) may help you determine how competitive the company is in each market. Is the company a leader in its industry or the specific target markets? Is the industry growing?

Information about competitors can be found in company profiles on most major research sites, usually along with a list of certain metrics already calculated for you. Performing due diligence on multiple companies in the same industry can provide investors with enormous insight as to how the industry is performing and what companies have a leading edge over the competition.

Step 4: Valuation Multiples

There are many ratios and financial metrics that investors can use to evaluate companies. There’s no one metric that’s ideal for all investments, so it’s best to utilize a combination of ratios to help generate a complete picture and lead to a more informed investment decision.

Some of the financial ratios include the price-to-earnings (P/E) ratio, price/earnings to growth (PEGs) ratio, and price-to-sales (P/S) ratio. As you calculate or research the ratios, compare the results to the company’s competitors. You might find yourself becoming more interested in a competitor during this step, but still, look to follow through with the original pick.

P/E ratios can form the initial basis for the company’s valuation. Earnings can and will have some volatility (even at the most stable companies). Investors should monitor valuations based on trailing earnings, or based on the last 12 months of earnings.

Basic “growth stock” versus “value stock” distinctions can be made, along with a general sense of how much expectation is built into the company. It’s generally a good idea to examine a few years’ worth of earnings figures and P/Es to make sure that the current quarter or year isn’t an aberration.

Not to be used in isolation, the P/E should be looked at in conjunction with the price-to-book (P/B) ratio, the enterprise multiple, and the price-to-sales (or revenue) ratio. These multiples highlight the valuation of the company as it relates to its debt, annual revenues, and balance sheet. Because ranges in these values differ from industry to industry, reviewing the same figures for some competitors or peers is a critical step. 

Finally, the PEG ratio brings into account the expectations for future earnings growth and how it compares to the current earnings multiple. For some companies, their PEG ratio may be less than one, while others might have a PEG of 10 or higher. Stocks with PEG ratios close to one are considered fairly valued under normal market conditions.

Step 5: Management and Share Ownership

Is the company still run by its founders? Or has management and the board shuffled in a lot of new faces? Younger companies tend to be founder-lead companies. Research the consolidated bios of management to see their areas of focus or whether they have broad experience. Bio information can be located on the company’s website.

Research if the founders and executives hold a high proportion of shares and whether they have been selling shares recently. Consider high ownership by top managers as a plus and low ownership a potential red flag. Shareholders tend to be best served when those running the company have a vested interest in the performance of the stock.

Step 6: Balance Sheet

Many articles could easily be devoted to just the balance sheet, but for our initial due diligence purposes, a cursory exam will suffice. The consolidated balance sheet will show the assets and liabilities as well as how much cash is available.

Also, monitor the level of debt and how that compares to companies in the industry. A lot of debt is not necessarily a bad thing, especially depending on the company’s business model and industry. But what are agency ratings for its corporate bonds? Does the company generate enough cash to service its debt and pay any dividends?

Some companies (and industries as a whole) are very capital intensive like oil and gas companies while others require few fixed assets and capital investment. Determine the debt-to-equity ratio to see how much positive equity the company has going for it; you can then compare the findings with competitors. Typically, the more cash a company generates, the better an investment it’s likely to be because it can service its debt and short-term obligations.

If the figures for total assets, total liabilities, and stockholders’ equity change substantially from one year to the next, try to determine the reason. Reading the footnotes that accompany the financial statements and the management’s discussion in the quarterly or annual reports can shed light on what’s happening with the company. The company could be preparing for a new product launch, accumulating retained earnings, or in a state of financial decline.

Step 7: Stock Price History

Investors should research both the short-term and long-term price movement of the stock and whether the stock has been volatile or steady. Compare the profits generated historically and determine how it correlated with the price movement. Keep in mind that past performance does not guarantee future price movements. If you’re a retiree looking for dividends, for example, you might not want a volatile stock price. Stocks that are continuously volatile tend to have short-term shareholders, which can add extra risk factors to certain investors.

Step 8: Stock Dilution Possibilities

Investors should know how many shares outstanding exist for the company and how that number relates to the competition. Is the company planning on issuing more shares or further diluting its share count? If so, the stock price might take a hit.

Step 9: Expectations

Investors should find out what the consensus of Wall Street analysts for earnings growth, revenue, and profit estimates are for the next two to three years. Investors should also research discussions of long-term trends affecting the industry and company-specific details about partnerships, joint ventures, intellectual property, and new products or services.

Step 10: Examine Long and Short-term Risks

Be sure to understand both the industry-wide risks and company-specific risks that exist. Are there outstanding legal or regulatory matters? Is there unsteady management?

Investors should keep a healthy game of devil’s advocate going at all times, picturing worst-case scenarios and their potential outcomes on the stock. If a new product fails or a competitor brings a new and better product forward, how would this affect the company? How would a jump in interest rates affect the company or how about economic growth and inflation?

Once you’ve completed the steps outlined above, investors you should get a better sense of the company’s performance and how it stacks up.

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