Due Diligence

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What is 'Due Diligence'

Due diligence is an investigation or audit of a potential investment to confirm all facts, such as reviewing all financial records, plus anything else deemed material. Due diligence refers to the care a reasonable person should take before entering into an agreement or a financial transaction with another party. When sellers perform a due diligence analysis on buyers, items that may be considered are the buyer's ability to purchase, as well as other elements that would affect the acquired entity or the seller after the sale has been completed.

An individual investor performs due diligence by studying annual reports, Securities and Exchange Commission (SEC) filings and other relevant information about a business and its securities. An investor verifies the material facts related to purchasing the investment and determines whether it fits his return requirements, risk tolerance, income needs and asset allocation goals. For example, an investor may read the company’s last two annual reports, several recent 10-Qs, and any independent research available. He can then develop a sense of where the business is heading, what market factors may affect the stock’s price and how volatile the stock is. The investor then has guidance on whether the investment is right for him, and how much and when to purchase it.

BREAKING DOWN 'Due Diligence'

Due diligence came into being when the U.S. Securities Act of 1933 was passed. Securities dealers and brokers became responsible for fully disclosing material information related to the instruments they were selling. Failing to disclose material information made dealers and brokers liable for criminal prosecution. However, creators of the Act understood that requiring full disclosure left the securities dealers and brokers vulnerable to unfair prosecution if they did not disclose a material fact they did not possess or could not have known at the time of sale. As a means of protecting the dealers and brokers, the Act included a legal defense that stated that as long as the dealers and brokers exercised due diligence when investigating companies whose equities they were selling, and fully disclosed their results to investors, they would not be held liable for information not discovered during the investigation.

What are Historic Cases of Companies Failing to Do their Due Diligence?

A historic case of a company failing to conduct proper due diligence is when Time Warner was acquired by America Online in January 2000. America Online was founded in the early 1980s as Control Video Corporation, and at that time it was a small, barely noticed technology company that changed names and focus several times. In 1991, Steve Case took over as CEO, and America Online went public on March 19, 1992. In 1993, the company had 600,000 subscribers. By 1996 it had ten times that number. When the company acquired Time Warner in 2000, it had 25 million subscribers and a market capitalization of $175 billion. Even with this growth and heady market cap, the company had relatively small revenues of $5 billion.

Time Warner, at the time of the merger, had a market capitalization of $90 billion and $27 billion in revenues. Markets saw America Online's growing profits as more valuable than Time Warner's more steady profits. The Nasdaq Composite Index and many technology companies were experiencing similar growth and valuations. Many believed they were on the brink of the dawn of a new era in publishing, and to some extent they were right. However, America Online never met up to these expectations. These factors led to Time Warner's CEO Gerald Levin allowing his company, with roots going back to 1922, to be acquired by America Online.

America Online's highly valued stock was the currency that permitted the transaction to take place. Teams of lawyers for both companies performed due diligence before the deal was approved, but the subsequent 80% decline in the value of the shares of AOL-Time Warner, the precipitous decline in America Online subscribers with the advent of broadband, DSL and other, faster Internet gateways, and the 2009 sale of America Online's (renamed AOL) assets by Time Warner for a fraction of their original worth (about $3.15 billion) suggests that this due diligence may have been performed hastily. It was the largest merger ever and has been called the worst in history.

What is a Due Diligence Meeting?

A due diligence meeting is the process of careful investigation by an underwriter to ensure that all material information pertinent to a security issue has been disclosed to prospective investors.

Before issuing a final prospectus, the underwriter, issuer and other individuals involved (such as accountants, syndicate members, and attorneys), will gather to discuss whether the underwriter and issuer have exercised due diligence toward state and federal securities laws. Below are steps to take to do your due diligence as an individual investor.

The Due Diligence Process 

Step 1: Analyze the Capitalization of the Company 

The first step in doing due diligence is to determine just how big the company is. The company’s market capitalization says a lot about how volatile the stock is likely to be, how broad the ownership might be and the potential size of the company's end markets. For example, large cap and mega cap companies tend to have more stable revenue streams and less volatility. Mid cap and small cap companies, meanwhile, may only serve single areas of the market, and may have more fluctuations in their stock price and earnings. (To learn more about market cap, see: Market Capitalization Defined and Determining What Market Cap Suits Your Style.) When you start to examine revenue and profit figures, the market cap will give you some perspective.

You should also confirm one other vital fact on this first check: what stock exchange do the shares trade on? Are they based in the United States (such as the New York Stock Exchange, Nasdaq, or over the counter)? Or, are they American depositary receipts (ADRs) with another listing on a foreign exchange? ADRs will typically have the letters "ADR" written somewhere in the reported title of the share listing. This information along with market cap should help answer basic questions like whether you can own the shares in your current investment accounts.

Step 2: Revenue, Profit, and Margin Trends

When beginning to look at the numbers, it may be best to start with the revenue, profit and margin (RPM) trends.

Look up the revenue and net income trends for the past two years at a general finance website. These should have links to quarterly (for the past 12 months) and annual reports (past three years). A quick calculator check could be done to confirm the price-to-sales (P/S) ratio and the price-to-earnings (P/E) ratio. Look at the recent trends in both sets of figures, noting whether growth is choppy or consistent, or if there any major swings (such as more than 50% in one year) in either direction.

Margins should also be reviewed to see if they are generally rising, falling, or remaining the same. This information will come into play more during the next step. 

Step 3: Competitors and Industries

Now that you have a feel for how big the company is and how much money it earns, it's time to size up the industries it operates in and who it competes with. Compare the margins of two or three competitors. Every company is partially defined by its competition. Looking at the major competitors in each line of business (if there is more than one) may help you nail down just how big the end markets for products are. Is the company being considered for investment a leader in its industry? 

Information about competitors can be found in company profiles on most major research sites, usually along with their ticker or direct comparisons that let you review a list of certain metrics filled in for both the company you're researching and its competitors. If you're still uncertain of how the company's business model works, you should look to fill in any gaps here before moving further along. Sometimes just reading about some of the competitors may help to understand what your target company does.

BlackBerry Ltd., formerly known as Research in Motion Ltd., was an undisputed leader until Apple Inc.’s iPhone and others like Samsung out-innovated BlackBerry. Investors aware of industry developments can better protect their investments.

Step 4: Valuation Multiples

Now it's time to get to the nitty-gritty of P/Es, price/earnings to growth (PEGs) ratio, and the like, for both the company and its competitors. Note any large discrepancies between competitors for further review. It's not uncommon to become more interested in a competitor during this step, which is perfectly fine but still look to follow through with the original due diligence while noting the other competing company for further review down the road.

P/E ratios can form the initial basis for looking at valuations. While earnings can and will have some volatility (even at the most stable companies), valuations based on trailing earnings or on current estimates are a yardstick that allows instant comparison to broad market multiples or direct competitors. Basic "growth stock" versus "value stock" distinctions can be made here along with a general sense of how much expectation is built into the company. It's generally a good idea to examine a few years' worth of net earnings figures to make sure most recent earnings figure (and the one used to calculate the P/E) is normalized, and not being thrown off by a significant one-time adjustment or charge.

Not to be used in isolation, the P/E should be looked at in conjunction with the price-to-book (P/B) ratio, the enterprise multiple, and the price-to-sales (or revenue) ratio. These multiples highlight the valuation of the company as it relates to its debt, annual revenues, and the balance sheet. Because ranges in these values differ from industry to industry, reviewing the same figures for some competitors or peers is a critical step. 

Finally, the PEG ratio brings into account the expectations for 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 management and the board shuffled in a lot of new faces? The age of the company is a big factor here, as younger companies tend to have more of the founding members still around. Look at consolidated bios of top managers to see what kind of broad experiences they have; this information may be found on the company's website or on SEC filings.

Also look to see if founders and managers hold a high proportion of shares, and what amount of the float is held by institutions. Institutional ownership percentages indicate how much analyst coverage the company is getting as well as factors influencing trade volumes. Consider high personal ownership by top managers as a plus, and low ownership a potential red flag. Shareholders tend to be best served when the people running the company have a stake in the performance of the stock. (To learn about the value of this vested interest see, check out: Evaluating A Company's Management and Delving Into Insider Investments.)

Step 6: Balance Sheet Exam

Many articles could easily be devoted to just the balance sheet, but for our initial due diligence purposes, a cursory exam will do. Look up a consolidated balance sheet to see the overall level of assets and liabilities, paying special attention to cash levels (the ability to pay short-term liabilities) and the amount of long-term debt held by the company. A lot of debt is not necessarily a bad thing, especially depending on the company's business model. Some companies (and industries as a whole) are very capital intensive, while others require little more than the basics of employees, equipment, and a novel idea to get up and running. Look at the debt-to-equity ratio to see how much positive equity the company has going for it; you can then compare this with the competitors to put the metric into better perspective. 

If the "top line" balance sheet figures of total assets, total liabilities and stockholders' equity change substantially from one year to the next, try to determine why. Reading the footnotes that accompany the financial statements and the management's discussion in the quarterly/annual report can shed some light on the situation. 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 having reviewed the recent profit trends. 

Step 7: Stock Price History

At this point, you'll want to nail down just how long all classes of shares have been trading, and both short-term and long-term price movement. Has the stock price been choppy and volatile, or smooth and steady? This outlines what kind of profit experience the average owner of the stock has seen, which can influence future stock movement. Stocks that are continuously volatile tend to have short-term shareholders, which can add extra risk factors to certain investors.

Step 8: Stock Options and Dilution Possibilities

Next, investors will need to dig into the 10-Q and 10-K reports. Quarterly SEC filings are required to show all outstanding stock options as well as the conversion expectations given a range of future stock prices. Use this to help understand how the share count could change under different price scenarios. While employee stock options are potentially a powerful motivator, watch out for shady practices like re-issuing of "underwater" options or any formal investigations that have been made into illegal practices like options backdating.

Step 9: Expectations

This is a sort of a "catch-all," and requires some extra digging. Investors should find out what the consensus revenue and profit estimates are for the next two to three years, long-term trends affecting the industry and company specific details about partnerships, joint ventures, intellectual property, and new products/services. News about a product or service on the horizon may be what initially turned you on to the stock, and now is the time to examine it more fully with the help of everything you've accumulated thus far.

Step 10: Examine Long and Short-term Risks

Setting this vital piece aside for the end makes sure that we're always emphasizing the risks inherent with investing. Make sure to understand both industry-wide risks and company-specific ones. Are there outstanding legal or regulatory matters, or just a spotty history with management? Is the company eco-friendly? And, what kind of long-term risks could result from it embracing/not embracing green initiatives? Investors should keep a healthy devil's advocate going at all times, picturing worst-case scenarios and their potential outcomes on the stock. 

Once you've completed these steps, you should be able to wrap your mind around what the company has done so far, and how it might fit into a broad portfolio or investment strategy. Inevitably you'll have specifics that you will want to research further, but following these guidelines should save you from missing something that could be vital to your decision. Veteran investors will throw many more investment ideas into the trash bin then they will keep for further review, so never be afraid to start over with a fresh idea and a new company. There are thousands of stocks to pick from. 

What are the Due Diligence Basics for Investing in a Startup?

When considering investing in a startup, follow the above-mentioned steps, in addition to the startup-specific criteria below. Investing in a startup carries a high level of risk, so here are basic steps you should consider.

  • Include an exit strategy when planning: More than 50% of startups fail within the first two years. Plan your divestment strategy to recover your investments should the business fail. This safeguards you from losing all of your investment.
  • Consider entering into a partnership: Partners split the capital and risk among themselves. Thus, there is a lower risk, and you lose fewer resources should the business fail in the first few years.
  • Figure out the harvest strategy for your investment: Promising businesses may fail due to a change in technology, government policy or the market. Be on the lookout for new trends, technologies and brands, and harvest when you find that the business may not thrive with the introduction of new factors in the market.
  • 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 the period. Furthermore, look at the growth plan of the business, and evaluate whether it is viable.