Due diligence is performed byequityresearch analysts, fund managers, broker-dealers, individual investors, and companies that are considering acquiring other companies. Due diligence by individual investors is voluntary. However, broker-dealers are legally obligated to conduct due diligence on a security before selling it.
How to Perform Due Diligence for Stocks
Below are 10 steps for individual investors undertaking due diligence. Most are related to stocks, but, in many cases, they can be applied tobonds, real estate, and many other investments.
After those 10 steps, we offer some tips when considering an investment in a startup company.
All of the information you need is readily available in the company's quarterly andannual reportsand in the company profiles on financial news and discount brokerage sites.
Step 1:AnalysetheCapitalisationof the Company
A company’smarket capitalisation, or total value, indicates how volatile the stock price is, how broad its ownership is, and the potential size of the company's target markets. Large-cap and mega-cap companies tend to have stable revenue streams and a large, diverse investor base, which tends to lead to less volatility. Mid-cap and small-cap companies typically have greater fluctuations in their stock prices andearningsthan large corporations.
Step 2: Revenue, Profit, and Margin Trends
The company's income statement will list its revenue or itsnet incomeor profit. That's the bottom line. It's important to monitor trends over time in a company's revenue, operating expenses,profit margins, andreturn on equity. The company's profit margin is calculated by dividing its net incomebyits revenue. It's best to analyse profit margin over several quarters or years and compare those results to companies within the same industry to gain some perspective.
Step 3: Competitors and Industries
Now that you have a feel for how big the company is and how much it earns, it's time to size up the industry in which it operates and its competition. Every company is defined in part by its competition. Due diligence involves comparing the profit margins of a company with two or three of its competitors.
For example, questions to ask are: Is the company a leader in its industry or its specific target markets?Is the company's industry growing?
Performing due diligence on several companies in the same industry can give an investor significant insight into how the industry is performing and which companies have the leading edge in that industry.
Step 4: Valuation Multiples
Manyratiosand financial metrics are used to evaluate companies, but three of the most useful are theprice-to-earnings(P/E) ratio, theprice/earnings to growth(PEGs) ratio,and price-to-sales (P/S) ratio. These ratios are already calculated for you on websites such as Yahoo! Finance.
As you research ratios for a company, compare several of its competitors. You might find yourself becoming more interested in a competitor.
- The P/E ratio gives you a general sense of how much expectation is built into the company's stock price. It's a good idea to examine this ratio over a few years to make sure that the current quarter isn't an aberration.
- Theprice-to-book (P/B) ratio, the enterprise multiple, and the price-to-sales (or revenue) ratio measure the valuation of the company in relation to its debt, annual revenues, and balance sheet. Peer comparison is important here because the healthy ranges differ from industry to industry.
- The PEG ratio suggests expectations among investors for the company's future earnings growth and how it compares to the current earnings multiple. 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 the board shuffled in a lot of new faces? Younger companies tend to be founder-led. Research the bios of management to find out their level of expertise and experience. Bio information can be found on the company's website.
P/E ratio
The P/E ratio gives a sense of the expectations that investors have for the stock's near-term performance.
Whether founders and executives hold a high proportion of shares and whether they have been selling shares recently is a significant factor in due diligence. High ownership by top managers is a plus, and low ownership is a red flag. Shareholders tend to be best served when those running the company have a vested interestin stock performance.
Step 6: Balance Sheet
The company's consolidatedbalance sheetwill show its assets and liabilities as well as how much cash is available.
Check the company's level ofdebtand how it compares to others in the industry. Debt is not necessarily a bad thing, depending on the company's business model and industry. But make sure those debts are highly rated by the rating agencies.
Some companies and whole industries, like oil and gas, are verycapitalintensive while others require few fixed assets and capital investment. Determine the debt-to-equity ratio to see how much positive equity the company has. Typically, the more cash a company generates, the better an investment it's likely to be because the company can meet its debts and still grow.
If the figures for total assets, total liabilities, andstockholders' equitychange substantially from one year to the next, try to figure out why. Reading the footnotes that accompany thefinancial statementsand the management's discussion in the quarterly or annual reports can shed light on what's really happening in a company. The firm could be preparing for a new product launch, accumulatingretained earnings, or in a state of financial decline.
Step 7: Stock Price History
Investors should research both the short-term and long-term price movements of the stock and whether the stock has been volatile or steady. Compare the profits generated historically and determine how it correlates 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 for certain investors.
Step 8: Stock Dilution Possibilities
Investors should know how many shares outstanding the company has and how that number relates to the competition. Is the company planning on issuing more shares? If so, the stock price might take a hit.
Step 9: Expectations
Investors should find out what theconsensusof Wall Street analysts is for earnings growth, revenue, and profit estimates for the next two to three years. Investors should also look for discussions of long-term trends affecting the industry and company-specific news 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. Are there outstanding legal or regulatory matters? Is there unsteady management?
Investors should play devil's advocate 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?
Once you've completed the steps outlined above, you'll have a better sense of the company's performance and how it stacks up to the competition. You will be better informed to make a sound decision.
