Broadly speaking, due diligence is when you conduct a review or audit to confirm facts or details of a pending or potential transaction. This could be an in-depth review of a business's financial or operating history before buying shares in the company.
How Due Diligence Works
The practice of conducting due diligence became commonplace in the US with the passing of the Securities Act of 1933. The passing of this law meant securities dealers and brokers were responsible for disclosing complete material information about the instruments they were selling. Failure to do so could leave them liable for criminal prosecution.
Investors can conduct due diligence on any stock by using available public information to help minimize risk from investment decisions. Thorough due diligence involves analyzing a company's financial records to compare them over specified periods and benchmarking them against similar companies.
Read Company Reports
Nowadays, getting your hands on a company's annual and quarterly reports is easy. The Investor relations section of the company website is a good starting point, but these forms can also be downloaded from the SEC's EDGAR Database. You should also read the proxy statement that includes management compensation, ownership, and potential conflicts of interest.
While carrying out due diligence, it's worth looking at the company's share ownership. Institutional ownership of more than 60% suggests the company is already well known. If these institutions all decide to sell at once, it could spell bad news for the share price.
However, if the largest shareholders are money management firms, managing the finances of individual investors, this could indicate further scope for share price growth.
Ten Due Diligence Steps
There are ten steps investors can take to conduct thorough due diligence. These are:
Analyze the company to gauge how volatile the stock is, how broad its ownership is and the size of the company's target markets. Its market capitalization and five-year share price movement make a good starting point.
Review company revenue, profit and margin trends over the past five years, or more, to determine its earnings and size.
Compare your findings from step 2 with competitors and companies operating in the same industry. This can provide a clearer perspective on the investing landscape or highlight signs of unusual activity.
Use financial ratios such as price-to-earnings ratio (P/E), PEG, or price-to-sales ratio (P/S) to evaluate the company. Also, check these metrics against competitors.
Determine the management and share ownership of the company. High share ownership by management and insiders is a good sign. Founder-led companies may have a competitive advantage as they have a long-term vested interest in seeing the company succeed. Low share ownership by leadership may be a red flag.
Study the balance sheet to check the company's level of debt. Compare its debt to its rivals to get a clear overview of the company's overall financial health.
Research the stock's short-term and long-term price movements to determine whether it is prone to volatility or steadiness.
Find out how many shares outstanding the company has and if they're planning on issuing more shares as this could impact stock price.
Listen to Wall Street analysts for any industry trends and understand general sentiment towards the company.
Understand the company's and the industry's short- and long-term risks, such as planned mergers, joint ventures, or new competitors.
Make More Informed Investment Decisions
Undertaking thorough due diligence can help investors make better-informed investment decisions. It provides a more precise overview of the company and the industry to determine whether it is a sound investment opportunity.
Mitigate Risk
While it is impossible to remove all risks entirely, due diligence can go a long way to mitigating risks. It can help investors understand any risks associated with the company or the industry before deciding to invest.
Drawbacks of Due Diligence
Can Be Complex
Conducting due diligence can be complex for investors new to the world of investments. Understanding how to read a balance sheet or analyze financial reports can take a special set of skills.
Investors May Miss Opportunities
Performing due diligence can be time-consuming, especially if you are not experienced in doing it. Taking time to do due diligence can lead investors to miss out on opportunities that require a quick decision.
Last Updated: 23 Jun 2022