What Is Due Diligence?
Due diligence is an investigation, audit, or review performed to confirm the facts 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 U.S. with the passage of the Securities Act of 1933. With that law, securities dealers and brokers became responsible for fully disclosing material information about the instruments they were selling. Failing to disclose this information to potential investors made dealers and brokers liable for criminal prosecution.
- The individual investor can conduct due diligence on any stock using readily available public information.
- The same strategy will work on many other types of investments.
- Look at the company's numbers. Compare the numbers over time. Compare them to their competitors' numbers.
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 did not possess or could not 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 could not be held liable for information that was not discovered during the investigation.
Types of Due Diligence
Due diligence is performed by companies considering acquiring other companies as well as by equity research analysts, fund managers, broker-dealers, and individual investors.
Due diligence by individual investors is voluntary. However, broker-dealers are legally obligated to conduct due diligence on a security before selling it.
Due Diligence for Stock Investors and Start-Up Investors
Below are 10 steps for individual investors undertaking due diligence. Most are related to stocks, but in many cases, they can be applied to bonds, real estate, and many other investments.
After those 10 steps are some tips for considering an investment in a startup company.
All of the information you need is readily available in the company's quarterly and annual reports and in the company profiles on financial news websites and on 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, 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 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's 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 dividing its net income by its revenue. It's best to analyze 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 it operates in and its competition. Every company is defined in part by its competition.
Compare the profit margins of two or three of its competitors. Is the company a leader in its industry or its specific target markets? And, is that industry growing?
Performing due diligence on several companies in the same industry can give an investor enormous insight into how the industry is performing and what companies have the leading edge in it.
Step 4: Valuation Multiples
Many 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. You'll find these 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.
- 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 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.
...gives you a sense of the expectations that investors have for the stock's near-term performance.
Find out if the founders and executives hold a high proportion of shares and whether they have been selling shares recently. 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 the performance of the stock.
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 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 very capital intensive 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. It's able to meet its debts and still grow.
If the figures for total assets, total liabilities, and stockholders' equity change substantially from one year to the next, 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 the company. It could be preparing for a new product launch, 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 movement 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 factors 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 the consensus of 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 keep a healthy attitude 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're ready 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 track record. Here are some startup-specific moves.
- Include an exit strategy. More than 50% of startups fail within the first two years. 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 if the business fails.
- Figure out the harvest strategy for your investment. Promising businesses may fail due to a change in technology, government policy, or market conditions. Be on the lookout 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, look at the growth plan of the business and evaluate whether it appears to be realistic.
Special Considerations: Soft and Hard Due Diligence
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, within the company and in its customer base.
In traditional M&A activity, the acquiring firm deploys risk analysts who perform due diligence by studying costs, benefits, structures, assets, and liabilities. That's known colloquially 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's 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 many drivers of business success that numbers cannot fully capture, such as employee relationships, corporate culture, and leadership. When M&A deals fail, as more than 50% of them do, it is often because the human element is ignored.
Contemporary business analysis calls this element human capital. The corporate world started taking notice of 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 an 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, additional 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
- Analyzing the consumer market
- Seeking operating redundancies that can be eliminated
- Reviewing potential or ongoing litigation
- 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 acquiring corporation's culture.
Hard and soft due diligence intertwine when it comes to compensation and incentive programs. These programs are not only 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 cultural impact.
Soft due diligence is concerned with employee motivation, and compensation packages are specifically constructed to boost those motivations. It is not a panacea or a cure-all, but soft due diligence can help the acquiring 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 if the target employees accept the cultural and operational shifts from the takeover, the target customers and clients may well resent a change in service, products, or procedures. This is why many M&A analyses now include customer reviews, supplier reviews, and test market data.