Due Diligence Definition & Uses for Stocks - Investopedia

Due diligence is an investigation, audit, or review performed to confirm facts or details of a matter under consideration. In the financial world, ... TableofContents Expand TableofContents WhatIsDueDiligence? UnderstandingDueDiligence TypesofDueDiligence DueDiligenceforStocks DueDiligenceforStartups SpecialConsiderations DueDiligenceFAQs TheBottomLine Investing InvestingEssentials WhatIsDueDiligence? Duediligenceisaninvestigation,audit,orreviewperformedtoconfirmfactsordetailsofamatterunderconsideration.Inthefinancialworld,duediligencerequiresanexaminationoffinancialrecordsbeforeenteringintoaproposedtransactionwithanotherparty. KeyTakeaways Duediligenceisasystematicwaytoanalyzeandmitigateriskfromabusinessorinvestmentdecision.Anindividualinvestorcanconductduediligenceonanystockusingreadilyavailablepublicinformation.Thesameduediligencestrategywillworkonmanyothertypesofinvestments.Duediligenceinvolvesexaminingacompany'snumbers,comparingthenumbersovertime,andbenchmarkingthemagainstcompetitors.Duediligenceisappliedinmanyothercontexts,forexample,conductingabackgroundcheckonapotentialemployeeorreadingproductreviews. 1:38 DueDiligence UnderstandingDueDiligence Duediligencebecamecommonpractice(andacommonterm)intheUnitedStateswiththepassageoftheSecuritiesActof1933.Withthatlaw,securitiesdealersandbrokersbecameresponsibleforfullydisclosingmaterialinformationabouttheinstrumentstheywereselling.Failingtodisclosethisinformationtopotentialinvestorsmadedealersandbrokersliableforcriminalprosecution. Thewritersoftheactrecognizedthatrequiringfulldisclosureleftdealersandbrokersvulnerabletounfairprosecutionforfailingtodiscloseamaterialfacttheydidnotpossessorcouldnothaveknownatthetimeofsale.Thus,theactincludedalegaldefense:aslongasthedealersandbrokersexercised"duediligence"wheninvestigatingthecompanieswhoseequitiestheywereselling,andfullydisclosedtheresults,theycouldnotbeheldliableforinformationthatwasnotdiscoveredduringtheinvestigation. TypesofDueDiligence Duediligenceisperformedbyequityresearchanalysts,fundmanagers,broker-dealers,individualinvestors,andcompaniesthatareconsideringacquiringothercompanies.Duediligencebyindividualinvestorsisvoluntary.However,broker-dealersarelegallyobligatedtoconductduediligenceonasecuritybeforesellingit. HowtoPerformDueDiligenceforStocks Beloware10stepsforindividualinvestorsundertakingduediligence.Mostarerelatedtostocks,but,inmanycases,theycanbeappliedtobonds,realestate,andmanyotherinvestments. Afterthose10steps,weoffersometipswhenconsideringaninvestmentinastartupcompany. Alloftheinformationyouneedisreadilyavailableinthecompany'squarterlyandannualreportsandinthecompanyprofilesonfinancialnewsanddiscountbrokeragesites. Step1:AnalyzetheCapitalizationoftheCompany  Acompany’smarketcapitalization,ortotalvalue,indicateshowvolatilethestockpriceis,howbroaditsownershipis,andthepotentialsizeofthecompany'stargetmarkets. Large-capandmega-capcompaniestendtohavestablerevenuestreamsandalarge,diverseinvestorbase,whichtendstoleadtolessvolatility.Mid-capandsmall-capcompaniestypicallyhavegreaterfluctuationsintheirstockpricesandearningsthanlargecorporations. Step2:Revenue,Profit,andMarginTrends Thecompany'sincomestatementwilllistitsrevenueoritsnetincomeorprofit.That'sthebottomline.It'simportanttomonitortrendsovertimeinacompany'srevenue,operatingexpenses,profitmargins,andreturnonequity. Thecompany'sprofitmarginiscalculatedbydividingitsnetincome by itsrevenue.It'sbesttoanalyzeprofitmarginoverseveralquartersoryearsandcomparethoseresultstocompanieswithinthesameindustrytogainsomeperspective. Step3:CompetitorsandIndustries Nowthatyouhaveafeelforhowbigthecompanyisandhowmuchitearns,it'stimetosizeuptheindustryinwhichitoperatesanditscompetition.Everycompanyisdefinedinpartbyitscompetition.Duediligenceinvolvescomparingtheprofitmarginsofacompanywithtwoorthreeofitscompetitors.Forexample,questionstoaskare:Isthecompanyaleaderinitsindustryoritsspecifictargetmarkets? Isthecompany'sindustrygrowing? Performingduediligenceonseveralcompaniesinthesameindustrycangiveaninvestorsignificantinsightintohowtheindustryisperformingandwhichcompanieshavetheleadingedgeinthatindustry. Step4:ValuationMultiples Manyratiosandfinancialmetricsareusedtoevaluatecompanies,butthreeofthemostusefularetheprice-to-earnings(P/E)ratio,theprice/earningstogrowth(PEGs)ratio, andprice-to-sales(P/S)ratio.TheseratiosarealreadycalculatedforyouonwebsitessuchasYahoo!Finance. Asyouresearchratiosforacompany,compareseveralofitscompetitors.Youmightfindyourselfbecomingmoreinterestedinacompetitor. TheP/Eratiogivesyouageneralsenseofhowmuchexpectationisbuiltintothecompany'sstockprice.It'sagoodideatoexaminethisratiooverafewyearstomakesurethatthecurrentquarterisn'tanaberration. Theprice-to-book(P/B)ratio,theenterprisemultiple,andtheprice-to-sales(orrevenue)ratiomeasurethevaluationofthecompanyinrelationtoitsdebt,annualrevenues,andbalancesheet.Peercomparisonisimportantherebecausethehealthyrangesdifferfromindustrytoindustry. ThePEGratiosuggestsexpectationsamonginvestorsforthecompany'sfutureearningsgrowthandhowitcomparestothecurrentearningsmultiple.StockswithPEGratiosclosetooneareconsideredfairlyvaluedundernormalmarketconditions. Step5:ManagementandShareOwnership Isthecompanystillrunbyitsfounders,orhastheboardshuffledinalotofnewfaces?Youngercompaniestendtobefounder-led.Researchthebiosofmanagementtofindouttheirlevelofexpertiseandexperience.Bioinformationcanbefoundonthecompany'swebsite. P/Eratio TheP/Eratiogivesasenseoftheexpectationsthatinvestorshaveforthestock'snear-termperformance. Whetherfoundersandexecutivesholdahighproportionofsharesandwhethertheyhavebeensellingsharesrecentlyisasignificantfactorinduediligence.Highownershipbytopmanagersisaplus,andlowownershipisaredflag.Shareholderstendtobebestservedwhenthoserunningthecompanyhaveavestedinterest instockperformance. Step6:BalanceSheet Thecompany'sconsolidatedbalancesheetwillshowitsassetsandliabilitiesaswellashowmuchcashisavailable. Checkthecompany'slevelofdebtandhowitcomparestoothersintheindustry.Debtisnotnecessarilyabadthing,dependingonthecompany'sbusinessmodelandindustry.Butmakesurethosedebtsarehighlyratedbytheratingagencies. Somecompaniesandwholeindustries,likeoilandgas,areverycapitalintensivewhileothersrequirefewfixedassetsandcapitalinvestment.Determinethedebt-to-equityratiotoseehowmuchpositiveequitythecompanyhas.Typically,themorecashacompanygenerates,thebetteraninvestmentit'slikelytobebecausethecompanycanmeetitsdebtsandstillgrow. Ifthefiguresfortotalassets,totalliabilities,andstockholders'equitychangesubstantiallyfromoneyeartothenext,trytofigureoutwhy.Readingthefootnotesthataccompanythefinancialstatementsandthemanagement'sdiscussioninthequarterlyorannualreportscanshedlightonwhat'sreallyhappeninginacompany.Thefirmcouldbepreparingforanewproductlaunch,accumulatingretainedearnings,orinastateoffinancialdecline. Step7:StockPriceHistory Investorsshouldresearchboththeshort-termandlong-termpricemovementsofthestockandwhetherthestockhasbeenvolatileorsteady.Comparetheprofitsgeneratedhistoricallyanddeterminehowitcorrelateswiththepricemovement. Keepinmindthatpastperformancedoesnotguaranteefuturepricemovements.Ifyou'rearetireelookingfordividends,forexample,youmightnotwantavolatilestockprice.Stocksthatarecontinuouslyvolatiletendtohaveshort-termshareholders,whichcanaddextrariskforcertaininvestors. Step8:StockDilutionPossibilities Investorsshouldknowhowmanysharesoutstandingthecompanyhasandhowthatnumberrelatestothecompetition.Isthecompanyplanningonissuingmoreshares?Ifso,thestockpricemighttakeahit. Step9:Expectations InvestorsshouldfindoutwhattheconsensusofWallStreetanalystsisforearningsgrowth,revenue,andprofitestimatesforthenexttwotothreeyears.Investorsshouldalsolookfordiscussionsoflong-termtrendsaffectingtheindustryandcompany-specificnewsaboutpartnerships,jointventures,intellectualproperty,andnewproductsorservices. Step10:ExamineLongandShort-TermRisks Besuretounderstandboththeindustry-widerisksandcompany-specificrisks.Arethereoutstandinglegalorregulatorymatters?Isthereunsteadymanagement? Investorsshouldplaydevil'sadvocateatalltimes,picturingworst-casescenariosandtheirpotentialoutcomesonthestock. Ifanewproductfailsoracompetitorbringsanewandbetterproductforward,howwouldthisaffectthecompany?Howwouldajumpininterestratesaffectthecompany? Onceyou'vecompletedthestepsoutlinedabove,you'llhaveabettersenseofthecompany'sperformanceandhowitstacksuptothecompetition.Youwillbebetterinformedtomakeasounddecision. DueDiligenceBasicsforStartupInvestments Whenconsideringinvestinginastartup,someofthe10stepsaboveareappropriatewhileothersjustaren'tpossiblebecausethecompanydoesn'thavethetrackrecord.Herearesomestartup-specificmoves. Includeanexitstrategy.Planastrategytorecoveryourmoneyshouldthebusinessfail. Considerenteringintoapartnership:Partnerssplitthecapitalandrisk,sotheyloselessifthebusinessfails. Figureouttheharveststrategyforyourinvestment.Promisingbusinessesmayfailduetoachangeintechnology,governmentpolicy,ormarketconditions.Beonthelookoutfornewtrends,technologies,andbrands,andgetreadytoharvestwhenyoufindthatthebusinessmaynotthrivewiththechanges. Chooseastartupwithpromisingproducts.Sincemostinvestmentsareharvestedafterfiveyears,itisadvisabletoinvestinproductsthathaveanincreasingreturnoninvestment(ROI)forthatperiod. Inlieuofhardnumbersonpastperformance,lookatthegrowthplanofthebusinessandevaluatewhetheritappearstoberealistic. SpecialConsiderations Inthemergersandacquisitions(M&A)world,thereisadelineationbetween"hard"and"soft"formsofduediligence. "Hard"duediligenceisconcernedwiththenumbers."Soft"duediligenceisconcernedwiththepeoplewithinthecompanyandinitscustomerbase. IntraditionalM&Aactivity,theacquiringfirmdeploysriskanalystswhoperformduediligencebystudyingcosts,benefits,structures,assets,andliabilities.That'sknowncolloquiallyashardduediligence. Increasingly,however,M&Adealsarealsosubjecttothestudyofacompany'sculture,management,andotherhumanelements.That'sknownassoftduediligence. Hardduediligence,whichisdrivenbymathematicsandlegalities,issusceptibletorosyinterpretationsbyeagersalespeople.Softduediligenceactsasacounterbalancewhenthenumbersarebeingmanipulatedoroveremphasized. Therearemanydriversofbusinesssuccessthatnumberscannotfullycapture,suchasemployeerelationships,corporateculture,andleadership.WhenM&Adealsfail,asanestimated70%-90%ofthemdo,itisoftenbecausethehumanelementisignored. Thecontemporarybusinessanalysiscallsthiselementhumancapital.Thecorporateworldstartedtakingnoticeofitssignificanceinthemid-2000s.In2007,theHarvardBusinessReviewdedicatedpartofitsAprilissuetowhatitcalled"humancapitalduediligence,"warningthatcompaniesignoreitattheirperil. PerformingHardDueDiligence InanM&Adeal,hardduediligenceisthebattlefieldoflawyers,accountants,andnegotiators.Typically,hardduediligencefocusesonearningsbeforeinterest,taxes,depreciationandamortization(EBITDA),theagingofreceivables,andpayables,cashflow,andcapitalexpenditures. Insectorssuchastechnologyormanufacturing,additionalfocusisplacedonintellectualpropertyandphysicalcapital. Otherexamplesofhardduediligenceactivitiesinclude: ReviewingandauditingfinancialstatementsScrutinizingprojectionsforfutureperformanceAnalyzingtheconsumermarketSeekingoperatingredundanciesthatcanbeeliminatedReviewingpotentialorongoinglitigationReviewingantitrustconsiderationsEvaluatingsubcontractorandotherthird-partyrelationships PerformingSoftDueDiligence Conductingsoftduediligenceisnotanexactscience.Itshouldfocusonhowwellatargetedworkforcewillmeshwiththeacquiringcorporation'sculture. Hardandsoftduediligenceintertwinewhenitcomestocompensationandincentiveprograms.Theseprogramsarenotonlybasedonrealnumbers,makingthemeasytoincorporateintopost-acquisitionplanning,buttheycanalsobediscussedwithemployeesandusedtogaugeculturalimpact. Softduediligenceisconcernedwithemployeemotivation,andcompensationpackagesarespecificallyconstructedtoboostthosemotivations.Itisnotapanaceaoracure-all,butsoftduediligencecanhelptheacquiringfirmpredictwhetheracompensationprogramcanbeimplementedtoimprovethesuccessofadeal. Softduediligencecanalsoconcernitselfwiththetargetcompany'scustomers.Evenifthetargetemployeesaccepttheculturalandoperationalshiftsfromthetakeover,thetargetcustomersandclientsmaywellresentachangeinservice,products,orprocedures.ThisiswhymanyM&Aanalysesnowincludecustomerreviews,supplierreviews,andtestmarketdata. DueDiligenceFAQs WhatExactlyIsDueDiligence? Duediligenceisaprocessorefforttocollectandanalyzeinformationbeforemakingadecision.Itisaprocessoftenusedbyinvestorstoassessrisk.Itinvolvesexaminingacompany'snumbers,comparingthenumbersovertime,andbenchmarkingthemagainstcompetitorstoassessaninvestment'spotentialintermsofgrowth. WhatIsthePurposeofDueDiligence? Duediligenceisprimarilyawaytoreduceexposuretorisk.Theprocessensuresthatapartyisawareofallthedetailsofatransactionbeforetheyagreetoit.Forexample,abroker-dealerwillgiveaninvestortheresultsofaduediligencereportsothattheinvestorisfullyinformedandcannotholdthebroker-dealerresponsibleforanylosses. WhatAretheTypesofDueDiligence? Dependingonitspurpose,duediligencetakesdifferentforms.AcompanythatisconsideringanM&Awillperformafinancialanalysisonatargetcompany.Theduediligencemightalsoincludeananalysisoffuturegrowth.Theacquirermayaskquestionsthataddressthestructuringoftheacquisition.Theacquirerisalsolikelytolookatthecurrentpracticesandpoliciesofthetargetcompanyandperformashareholdervalueanalysis.Duediligencecanbecategorizedas"hard"duediligence,whichisconcernedwiththenumbersonthefinancialstatements,and"soft"duediligence,whichisconcernedwiththepeoplewithinthecompanyanditscustomerbase. WhatIsaDueDiligenceChecklist? Aduediligencechecklistisanorganizedwaytoanalyzeacompany.Thechecklistwillincludealltheareastobeanalyzed,suchasownershipandorganization,assetsandoperations,thefinancialratios,shareholdervalue,processesandpolicies,futuregrowthpotential,management,andhumanresources. WhatIsaDueDiligenceExample? Examplesofduediligencecanbefoundinmanyareasofourdailylives.Forexample,conductingapropertyinspectionbeforecompletingapurchasetoassesstheriskoftheinvestment,anacquiringcompanythatexaminesatargetfirmbeforecompletingamergeroracquisition,andanemployerperformingabackgroundcheckonapotentialrecruit. TheBottomLine Duediligenceisaprocessorefforttocollectandanalyzeinformationbeforemakingadecisionorconductingatransactionsoapartyisnotheldlegallyliableforanylossordamage.Thetermappliestomanysituationsbutmostnotablytobusinesstransactions.Duediligenceisperformedbyinvestorswhowanttominimizerisk,broker-dealerswhowanttoensurethatapartytoanytransactionisfullyinformedofthedetailssothatthebroker-dealerisnotheldresponsible,andcompanieswhoareconsideringacquiringanotherfirm.Fundamentally,doingyourduediligencemeansthatyouhavegatheredthenecessaryfactstomakeawiseandinformeddecision. ArticleSources Investopediarequireswriterstouseprimarysourcestosupporttheirwork.Theseincludewhitepapers,governmentdata,originalreporting,andinterviewswithindustryexperts.Wealsoreferenceoriginalresearchfromotherreputablepublisherswhereappropriate.Youcanlearnmoreaboutthestandardswefollowinproducingaccurate,unbiasedcontentinour editorialpolicy. Govinfo.gov."SecuritiesActof1933." HarvardBusinessReview."Don'tMakeThisCommonM&AMistake." BusinessHarvardReview."HumanDueDiligence." CompareAccounts AdvertiserDisclosure × TheoffersthatappearinthistablearefrompartnershipsfromwhichInvestopediareceivescompensation.Thiscompensationmayimpacthowandwherelistingsappear.Investopediadoesnotincludealloffersavailableinthemarketplace. Provider Name Description RelatedTerms WhatIsaFiduciary? Afiduciaryisapersonororganizationthatactsonbehalfofapersonorpersonsandislegallyboundtoactsolelyintheirbestinterests. more WhatIsVentureCapital? Venturecapitalismoney,technical,ormanagerialexpertiseprovidedbyinvestorstostartupfirmswithlong-termgrowthpotential. more MergersandAcquisitions(M&A) Mergersandacquisitions(M&A)referstotheconsolidationofcompaniesorassetsthroughvarioustypesoffinancialtransactions. more TheVettingProcessDefined Vettingreferstotheprocessofinvestigatinganindividual,company,orentitybeforedecidingtogoforwardwithahireorajointproject. more Risk Risktakesonmanyformsbutisbroadlycategorizedasthechanceanoutcomeorinvestment'sactualreturnwilldifferfromtheexpectedoutcomeorreturn. more WhatIsanEventStudy? Aneventstudyisastatisticalmethodologyusedtoevaluatetheimpactofaspecificeventorpieceofnewsonacompanyanditsstock. more PartnerLinks RelatedArticles FundamentalAnalysis AnalyzingRetailStocks TopStocks ABeginner'sGuidetoBuyingFacebook(Meta)Stock WarrenBuffett WhatIsWarrenBuffett'sInvestmentStartegy? 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