Due Diligence

What Is Due Diligence?

Due diligence is an investigation, audit, or review performed to confirm facts or details of a matter under consideration. In the financial world, due diligence requires an examination of financial records before entering into a proposed transaction with another party.

Understanding Due Diligence

Due diligence became common practice (and a common term) in the United States with the passage of the Securities Act of 1933. With that law, securities dealers and brokers became responsible for fully disclosing material data about the instruments they were selling. Failing to disclose this data to potential investors made dealers and brokers liable for criminal prosecution.

The writers of the act recognized that requiring full disclosure left dealers and brokers vulnerable to unfair prosecution for failing to disclose a material fact they didn't possess or could never have known at the time of sale. Thus, the act included a legal defense: as long as the dealers and brokers exercised "due diligence" when investigating the companies whose equities they were selling, and fully disclosed the results, they couldn't be held liable for data that was not discovered during the investigation.

Types of Due Diligence

Due diligence is performed by equity research analysts, fund managers, broker-dealers, individual investors, and companies that are considering gaining 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.

The most effective method to Perform Due Diligence for Stocks

Below are 10 steps for individual investors undertaking due diligence. Most are related to stocks, but, much of the time, they can be applied to bonds, real estate, and numerous other investments.

After those 10 steps, we offer some tips when considering an investment in a startup company.

The data you need is all readily available in the company's quarterly and annual reports and in the company profiles on financial news and discount brokerage sites.

Step 1: Analyze the Capitalization of the Company

A company's market capitalization, or total value, indicates how volatile the stock price is, the way 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 and earnings than large corporations.

Step 2: Revenue, Profit, and Margin Trends

The company's income statement will list its revenue or its net income or profit. That is the bottom line. It's important to monitor trends over time in a company's revenue, operating expenses, profit margins, and return on equity.

The company's profit margin is calculated by partitioning its net income by its revenue. It's best to analyze profit margin over several quarters or years and compare those results to companies inside the same industry to gain some perspective.

Step 3: Competitors and Industries

Since you have a feel for how big the company is and the amount it earns, now is the right 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 a few 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 developing?

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

Numerous ratios and financial metrics are used to evaluate companies, but three of the most useful are the price-to-earnings (P/E) ratio, the price/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 could end up 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 really smart to examine this ratio over a few years to make sure that the current quarter isn't an aberration.
The price-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 one industry to another.
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 genuinely valued under normal market conditions.

Is the company still run by its founders, or has the board shuffled in a ton of new faces? Younger companies tend to be founder-led. Research the bios of management to figure out their level of expertise and experience. Bio data 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 interest in stock performance.

Step 6: Balance Sheet

The company's consolidated balance sheet will show its assets and liabilities as well as how much cash is available.

Check the company's level of debt and how it compares to others in the industry. Debt is not necessarily something bad, 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 very capital intensive while others require few fixed assets and capital investment. Determine the debt-to-equity ratio to see the amount of positive equity the company possesses. Typically, the more cash a company generates, the better an investment it's likely to be because the company can meet its debts regardless develop.

If the figures for total assets, total liabilities, and stockholders' equity change substantially over time, try to figure out why. 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 really happening in a company. The firm could be preparing for a new product send off, 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 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 as a primary concern that past performance does not guarantee future price movements. In the event that you're a retiree searching for dividends, for example, you probably won't need 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 the number of shares outstanding the company that has and how that number relates to the competition. Is the company planning on issuing more shares? Provided that this is true, the stock price could take a hit.

Step 9: Expectations

Investors should figure out what the consensus of Wall Street analysts is for earnings growth, revenue, and profit estimates for the next a few years. Investors should also search 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 consistently, picturing worst-case scenarios and their potential outcomes on the stock. On the off chance that a new product fails or a competitor brings a new and better product forward, how might this affect the company? How might 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 the way that it stacks up to the competition. You will be better informed to make a sound decision.

Due Diligence Basics for Startup Investments

When considering investing in a startup, some of the 10 steps above are appropriate while others just aren't possible because the company doesn't have the history. Here are some startup-specific moves.

Include an exit strategy. Plan a strategy to recover your money should the business fail.
Consider entering into a partnership: Partners split the capital and risk, so they lose less in the event that the business fails.
Figure out the harvest strategy for your investment. Promising businesses might fail due to a change in technology, government policy, or market conditions. Be watching out for new trends, technologies, and brands, and get ready to harvest when you find that the business may not thrive with the changes.
Choose a startup with promising products. Since most investments are harvested after five years, it is advisable to invest in products that have an increasing return on investment (ROI) for that period.
In lieu of hard numbers on past performance, take a gander at the growth plan of the business and evaluate whether it appears to be realistic.

Special Considerations

In the mergers and acquisitions (M&A) world, there is a delineation between "hard" and "soft" forms of due diligence.

"Hard" due diligence is concerned with the numbers. "Soft" due diligence is concerned with the people inside the company and in its customer base.

In traditional M&A activity, the gaining firm deploys risk analysts who perform due diligence by studying costs, benefits, structures, assets, and liabilities. That is referred to conversationally as hard due diligence.

Increasingly, however, M&A deals are also subject to the study of a company's culture, management, and other human elements. That is known as soft due diligence.

Hard due diligence, which is driven by mathematics and legalities, is susceptible to rosy interpretations by eager salespeople. Soft due diligence acts as a counterbalance when the numbers are being manipulated or overemphasized.

There are numerous drivers of business success that numbers can't fully capture, such as employee relationships, corporate culture, and leadership. When M&A deals fail, as more than half of them do, it is often because the human element is ignored.

The contemporary business analysis calls this element human capital. The corporate world started paying heed to its significance in the mid-2000s. In 2007, the Harvard Business Review dedicated part of its April issue to what it called "human capital due diligence," warning that companies ignore it at their peril.

Performing Hard Due Diligence

In a M&A deal, hard due diligence is the battlefield of lawyers, accountants, and negotiators. Typically, hard due diligence focuses on earnings before interest, taxes, depreciation and amortization (EBITDA), the aging of receivables, and payables, cash flow, and capital expenditures.

In sectors such as technology or manufacturing, extra focus is placed on intellectual property and physical capital.

Other examples of hard due diligence activities include:

Reviewing and auditing financial statements
Scrutinizing projections for future performance
Examining the consumer market
Seeking operating redundancies that can be eliminated
Reviewing potential or progressing prosecution
Reviewing antitrust considerations
Evaluating subcontractor and other third-party relationships

Performing Soft Due Diligence

Conducting soft due diligence is not an exact science. It should focus on how well a targeted workforce will mesh with the procuring corporation's culture.

Hard and soft due diligence intertwine when it comes to compensation and incentive programs. These programs are not just based on real numbers, making them easy to incorporate into post-acquisition planning, but they can also be discussed with employees and used to gauge social impact.

Soft due diligence is concerned with employee motivation, and compensation packages are specifically constructed to boost those motivations. It's anything but a panacea or a cure-all, but soft due diligence can help the getting firm predict whether a compensation program can be implemented to improve the success of a deal.

Soft due diligence can also concern itself with the target company's customers. Even assuming the target employees accept the social and operational shifts from the takeover, the target customers and clients might well resent a change in service, products, or procedures. This is the reason numerous M&A analyses presently include customer reviews, supplier reviews, and test market data.

Due Diligence FAQs

What Exactly Is Due Diligence?

Due diligence is a process or effort to collect and analyze data before pursuing a choice. It is a process often used by investors to assess risk. It involves examining a company's numbers, comparing the numbers over time, and benchmarking them against competitors to assess an investment's potential in terms of growth.

What Is the Purpose of Due Diligence?

Due diligence is primarily a method for reducing exposure to risk. The process ensures that a party is aware of the multitude of details of a transaction before they agree to it. For example, a broker-dealer will give an investor the results of a due diligence report so that the investor is fully informed and can't hold the broker-dealer responsible for any losses.

What Are the Types of Due Diligence?

Depending on its purpose, due diligence takes different forms. A company that is considering a M&A will perform a financial analysis on a target company. The due diligence could also include an analysis of future growth. The acquirer might ask questions that address the structuring of the acquisition. The acquirer is also likely to take a gander at the current practices and policies of the target company and perform a shareholder value analysis. Due diligence can be categorized as "hard" due diligence, which is concerned with the numbers on the financial statements, and "soft" due diligence, which is concerned with the people inside the company and its customer base.

What Is a Due Diligence Checklist?

A due diligence checklist is an organized method for breaking down a company. The checklist will include every one of the areas to be analyzed, such as ownership and organization, assets and operations, the financial ratios, shareholder value, processes and policies, future growth potential, management, and human resources.

What Is a Due Diligence Example?

Examples of due diligence can be found in numerous areas of our daily lives. For example, conducting a property inspection before completing a purchase to assess the risk of the investment, a securing company that examines a target firm before completing a merger or acquisition, and an employer performing a background check on a potential recruit.

The Bottom Line

Due diligence is a process or effort to collect and analyze data before going with a choice or conducting a transaction so a party is not held legally liable for any loss or damage. The term applies to numerous situations but most notably to business transactions. Due diligence is performed by investors who need to minimize risk, broker-dealers who need to ensure that a party to any transaction is fully informed of the details so that the broker-dealer is not held responsible, and companies who are considering obtaining another firm. Fundamentally, taking care of any outstanding concerns means that you have gathered the necessary facts to make a wise and informed decision.

Highlights

Due diligence is applied in numerous other contexts, for example, conducting a background check on a potential employee or reading product reviews.
Due diligence involves examining a company's numbers, comparing the numbers over time, and benchmarking them against competitors.
Due diligence is a systematic method for breaking down and mitigate risk from a business or investment decision.
The same due diligence strategy will deal with numerous other types of investments.
An individual investor can conduct due diligence on any stock using readily available public data.