Due diligence before a potential stock investment involves a thorough investigation of several factors impacting its future performance.
This article highlights how to conduct due diligence using a checklist to tick off the relevant questions about the fundamental aspects of a company you have picked.
When you plan to buy a house, car, or smartphone, you check the specifications, utility, price point, quality, and overall ability of the asset to fulfill your needs. Why should stocks be different? You invest a good portion of your money in stocks, and you should conduct thorough due diligence before purchasing them.
Without proper research, investing in the stock market is a sure-shot recipe for disaster. The performance of a stock is subject to plenty of factors, and if you don’t understand them, you wouldn’t know how to manage your portfolio. If your investment decision is not backed by in-depth research, it exposes you to high risk, and you could lose all your money.
Learn how to do due diligence on a stock and the checklist you need to follow to safeguard your stock investments.
What Is Stock Due Diligence?
Due diligence for stock market investing or “DD” means conducting a thorough investigation of the various elements that influence the performance of a potential investment. This includes the macro factors, industry scenario, risk assessment, market capitalization, and financial performance. Stock due diligence is vital for an investor because it helps her take calculated risks—complete due diligence alongside a discounted cash flow analysis.
Due diligence became a common term in the United States after the Securities Act of 1933. That law held securities dealers and brokers accountable for disclosing material information about their sold instruments. Failure to disclose this information to potential investors was considered a criminal offense for dealers and brokers. Due diligence is primarily performed by equity research analysts, fund managers, broker-dealers, and savvy retail investors. Due diligence is a critical process to evaluate a potential investment, so one must pay maximum attention to each element of this exercise.
Due diligence is different from a stock valuation, and it also has nothing to do with deciding whether the stock is attractive or unattractive. Due diligence is a checklist of factors that you need to comply with before deciding on a stock. Valuation and due diligence go hand-in-hand.
Before conducting due diligence, you’ll want to screen for stocks that meet your investment criteria and perform a pricing exercise – in other words; due diligence is the last step in the process before making a final buy decision.
You must conduct the due diligence of the stock in the same way as you would before a business.
Research and due diligence are critical for any investor, especially beginner-level investors. In this age of information overload, we are constantly hounded by the latest hype in the stock markets like crypto, weed, or electric vehicle stocks. There is overanalysis at every step, and it ultimately becomes difficult to cut through the noise.
We could easily fall prey to overvalued stocks with bogus businesses. If we pay too much heed to every expert’s advice, we fail to make an informed decision. Here you rely on nothing but the research you have conducted and your investigation.
Stock market investing can be challenging if you fail to put in adequate fundamental analysis before making any decision. Without the well-designed, strategic due diligence process, you wouldn’t want to invest in individual stocks. To make the process simpler, here’s a due diligence checklist that contains the 16 most pertinent questions that you must seek an answer to before purchasing any stocks.
The first step towards Due Diligence is picking the stock. Let’s say a friend or an analyst on a stock market portal recommended the stock to you. Before purchasing individual stocks, you should evaluate the motive behind their recommendations. Did they suggest it to help you make a decision? Or did they recommend it because they have a vested interest?
To avoid this confusion, you may want to identify a stock yourself; however, to pick one stock from a vast universe is a cumbersome task and hence impractical. Hence, you may choose to stick to a subset of an industry or a particular sector to narrow down your choice using a stock screener.
A stock is not just a standalone asset; it represents a company. Hence, you need to educate yourself and understand the firm’s business model. A business model is a method by which a company earns money by selling its services/products, including what they do, why they do, and how they do it. You cannot buy a stock if you cannot understand the complexities of its business.
Start reading about the company profile and background stated in the SEC filings to understand a company. This is the best place to get an overview of the company and know the management’s vision. It’s challenging to understand every aspect in the initial stages of your research, but the more you read, the better you know. Besides understanding how the company makes money and its customers, you must also see how it has evolved over the years.
A company’s market cap measures its worth in the stock market, and it is calculated by adding the total market value of all outstanding shares.
The three broad categories in which companies can be classified are Large, mid, and small-cap. Large caps have a market capitalization of at least $10 billion or more, and they have robust and established operations. Large-cap companies also tend to make regular dividend payments, and their prices are less volatile.
Mid-cap stocks have a market cap ranging from 2 billion to 10 billion. These companies have been in business for a few years, and most of them are on the path to expansion. Many of the growth stocks fall in this category. As they aren’t as established as large caps, they are more exposed to risks and volatile prices. At the same time, small-cap companies are the ones that have a market capitalization of between 300 million and 2 billion.
Understanding the market capitalization of stocks is crucial because it explains where the company is in its lifecycle. It also depicts how broad the ownership might be and the potential size of its markets.
One of the critical aspects of the due diligence process is to ascertain the company’s financial health. You can jump to the financial section, which has the three financial statements: Income Statement, Balance Sheet, and Cash flow statement.
When you begin digging into the financials, start with the company’s revenues, profit, and margin trends. It’s best to look at the revenue or margin trends for the past five years to get a holistic picture. You can pick up the past SEC filings or the 10K to get the exact numbers.
Many sites like Yahoo Finance, Bloomberg, and Seeking Alpha give you a detailed snapshot of the historical financials. Not just that, most of these websites provide information on ratios like Price-to-sales (P/S), Price-to-Earnings (P/E), and Price to EBITDA (P/EBITBA). Look for the trend in these ratios. Have they been in the same range throughout, or have there been fluctuations? Bar and line charts are typically the best way to look for these trends.
You should also evaluate the company’s profit margins and check the trend. Have the margins been consistent, or have there been sudden variations? It’s best to check the company’s website, pull out management interviews, earnings calls, recordings of analyst days, as well as SEC filings to know the exact reasons. Besides revenue and margins, a vital part of the financial due diligence is to look for red flags in the balance sheet and cash flow statement. Some of the fundamental questions that you may want to analyze are:
- What is the primary source of the company’s income?
- What is the debtor cycle of the company?
- What is the amount of working capital locked up in inventories?
- Are the cash from operations adequate to fund the company’s capital expenditure?
You must also check if the company sufficiently provides for contingent liabilities in the balance sheet.
You must review your company’s balance sheet to assess the overall level of assets and liabilities, focusing on cash levels and the long-term debt. Debt isn’t a problematic factor; it’s usually necessary to fuel the company’s growth. There could be a new product launch, a possible acquisition, or an expansion into a new market. There could be endless reasons, but the quantum of debt should not destabilize the company’s business model.
It makes sense to evaluate the debt-to-equity ratio compared to the competitors’ to understand the scenario better. The company could be preparing for a new product launch, accumulating retained earnings, or simply whittling away at precious capital resources. What you see should start to have some deeper perspective after reviewing the recent profit trends.
Not just the balance sheet, it’s essential to know the off-balance sheet items as well. These include some contingent liabilities as well as inter-company or inter-departmental debt. Many companies choose not to show these items on the balance sheet to overstate their Return on Capital Employed or downplay their debt burden. Leases are also a part of off-balance sheet items depicted as borrowings.
While conducting the stock DD, can you miss the company’s management and ownership? It’s essential to check the educational and professional credentials of the founder and the top management. One of the most important factors is their experience in the industry and their reputation. Read the consolidated bios of top managers to see their experiences and qualifications. This information is readily available on its website or its Securities and Exchange Commission (SEC) filings.
Do you need to dig for all the management information and interviews to check the goals that the management has set for the company and has achieved them?
The compensation of the management is also a factor to be explored. It’s critical to check if the top leaders are getting sky-high compensation at the cost of shareholders’ money or if they have a properly aligned performance-based incentive scheme. Management reshuffling has severe repercussions for the company. It is pertinent to understand if the founder still runs the company or if leadership has tenure.
The proportion of shares that the management and founders hold plays a significant role. If the personal ownership by top managers is high, it is a good sign because it indicates that the owners have a stake in how the company performs. On the other hand, low ownership is a potential red flag.
Taking a look at the management behavior could reveal many things about the company. If the management sells a large proportion of shares for no apparent reason could mean that the administration feels that the company is overvalued. Other factors that you can consider are whether the management is buying the company’s stock.
P/E ratios are a good starting point to compare the stock’s valuation with its competitors. The earnings for even the most successful companies are bound to fluctuate. Hence, it is best to study the net profits over the past five to six years to assess whether the current earnings are consistent with the trends or a significant variation.
You may want to check the Price/Earnings growth ratio across peers to see if the company’s numbers are in line with the industry standards. The PEG ratio considers the expectations around potential earnings growth compared to the current earnings.
It would be best if you didn’t look at the P/E ratio or PEG ratio in isolation. You also need to evaluate valuation multiples like Price to Book ratio (P/B), Price to Sales (P/S), and Enterprise Value to EBITDA ratio. These ratios highlight the company’s value against the company’s sales, debt level, and enterprise value. As a prudent investor, you must conclude that the stock is ‘Cheap’ if all the methods yield the same result.
Finally, once you feel confident that your due diligence questions have been answered, you must complete a full discounted cash flow analysis.
Every investor knows that risks and profits are two sides of the same coin. These risks can be internal or external (industry and economy). Is the company embroiled in a legal controversy? Is any member of the top management facing a lawsuit? Are they offering ethical services to customers? Are their products a threat to the environment? What could be the risks of not following industry practices? Is the company making a reckless expenditure in recent times? Never take any press release or event at face value. There could be more than what meets the eye. Hence, always look at a company with an investigative mindset and understand the potential implications of any announcement or event related to the company.
Industry trends, technological trends, and regulations play a significant role in deciding the company’s future. There could be a lot of risks and opportunities surrounding the rules imposed by the government or industry. Predicting this factor is slightly dicey because it’s hard to predict the outcome of regulations.
It is best to conclude once the regulation has come under effect. You can look at the historical instances to evaluate the impact of the various rules on the company and the stock. If you plan to hold the stock for the long term, you need to check how it will respond to any technological disruption or regulation.
A company’s historical stock performance helps understand the investor community’s overall interest in the stock and the future course of movement. You would want to check the duration for which all the classes of stocks have been trading and their price movement.
Does the price trend depict volatility or a smooth movement? Stocks that are constantly volatile often lack long-term shareholders, which can also be a risk factor. Along with the historical price trend, it is also intelligent to look at the stock’s trading volume to judge its appeal amongst investors.
Several websites and mobile apps are used to find historical stock quotes–both real-time and historical quotes and financial metrics across all categories. Yahoo! Finance, Bloomberg, and Marketwatch are some of these sites.
Financial due diligence is just one of the basic steps, and the picture would be incomplete if we did not take the projections into account. You might consider seeing consensus revenue and margin estimates over two to three years. This includes the industry-specific predictions and the impact of new partnerships, alliances, joint ventures, and new products and services. Try to get your hands on analyst estimates, industry reports, interviews of CEOs, and market projections.
Governance is a significant factor for stock due diligence. Its a set of rules, controls, policies, and resolutions that shows whether the management’s interests are aligned with the well-being of the shareholders. There have been instances when the companies have borrowed beyond their means to avoid diluting the equity.
This has caused a lot of harm to the investors and exposed them to many financial risks. Corporate governance is crucial to investors because it depicts its direction and business integrity. Consequently, corporate governance also creates a long-term investment opportunity and makes it a financially attractive option for participants.
Being profitable is not the only reason for a company to exist; it also needs to be a good corporate citizen. Good corporate governance forms a transparent set of rules and controls in which shareholders, directors, and officers have aligned incentives.
When a company is expanding, it is essential to check the ROE or return on equity. ROE stands for the profitability of the business and asset utilization efficiency. If the ROE is more than the cost of equity, your company is adding value for you.
The last thing that you might want to tick off your due-diligence checklist is whether the stock is a good fit for your long-term financial goals. The stock might be outstanding and fulfill all the criteria you had set for it, but what good is it if it’s not aligned with the long-term financial goals. If the stock only adds to your risk, you would rather not have it in your portfolio.
The equity due diligence checklist is a kind of a final sign-off document that ensures that after all the research is done, you take a second look at the key aspects. It helps to make your investment decision process more refined!
A company with a substantial competitive advantage will be able to safeguard its long-term profits. These advantages could be a brand name, pricing power, or a more significant market share. Competitive advantage or moat, as Warren Buffet calls it, must also be sustainable in the long run. When a company has a significant competitive advantage, it could be difficult for its rivals to capture its market share.
To assess its size, you must consider how it is positioned within the industry against its competitors. Pick two-three direct competitors and compare their margins. Study the company’s performance to its peers, including its financials, market share, products/services, and operations. That’s the best way to know how the business is placed in the market.
Most stock research sites showcase information about the company’s competitors, which will help you compare specific metrics for all the companies directly. Also, try to read more about its competitors to understand what’s unique about your company’s business model and product proposition and what competition views as their long-term risks.
A manufacturing company’s research and development efforts are critical; therefore, you should pick those with a highly qualified and efficient research-and-development (R&D) team. It is essential to understand that the R&D expenses are an integral part of the company’s operating cost, and it signifies initiative toward the development of a new product or service.
A company that allocates a sizeable amount of R&D is undoubtedly a progressive one, but you still need to check how it finances these initiatives. You also need to watch the ratio of R&D expenses to sales over the past five years to check if there is any sudden increase/decrease and its impact on the company’s bottom line.
Human capital is the most significant investment that a company can make today. A company that treasures its workforce and has good labor relations has the edge over its competitors. Happy employees are super productive; on the flip side, a company with labor tensions and a high attrition rate has to bear the brunt of workforce strikes. Thus investors must look at the condition of a company’s labor relations by considering a few factors like how the company addresses employee grievances and investment in human capital.
Conflicts are bound to happen between the management and employees, but how the company’s management communicates and resolves the disputes speaks a lot about their people management qualities. It shows how much they value the co-operation of their workforce towards a unified progress plan.
Before investing in a company, you need to pay attention to a company’s cost-reduction and profit-maximization strategies. Companies that conduct a periodic review of their operational costs and control it are more likely to earn consistent profits in the long run. These are also the companies that see an expansion.
Performing due diligence for your stock doesn’t imply making any drastic judgments regarding the stock. Your focus should be putting your efforts into accumulating information that will set the base for further fundamental analysis.
After you follow the steps in the checklist, you will be better equipped to evaluate the company’s profit potential and how the stock might fare in your portfolio. If you feel that the stock wouldn’t add value to your investment strategy after all the hard work and due diligence, don’t think twice to drop it and pick another one.
Due diligence or stock DD is the starting point of analysis for beginners and professionals alike. It’s not a surefire way to create a winning portfolio but a way of filtering existing and future investments. Due diligence allows you to confidently invest because you understand what you are buying into rather than just giving in to the hype and making bad investments.