What is Due Diligence

Due diligence is an investigation or audit of a potential investment or product to confirm all facts, that might include the review of financial records. Due diligence refers to the research done before entering into an agreement or a financial transaction with another party.

Investors perform due diligence before buying a security from a company. Due diligence can also refer to the investigation a seller performs on a buyer that might include whether the buyer has adequate resources to complete the purchase.

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Due Diligence

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. Securities dealers and brokers became responsible for fully disclosing material information related to the instruments they were selling. Failing to disclose this information to potential investors 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 them, 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.

Types of Due Diligence

Due diligence is performed by companies seeking to make acquisitions, by equity research analysts, by fund managers, broker-dealers, and investors. The due diligence on a security by investors is voluntary. However, broker-dealers are legally obligated to conduct due diligence on a security before selling it, which helps to prevent any issues arising with non-disclosure of pertinent information.

A standard part of an initial public offering is the due diligence meeting, a process of careful investigation by an underwriter to ensure that all material information pertinent to the 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.

The Due Diligence Process for Stock Investing

Below are detailed steps for individual investors undertaking due diligence. Most are related to equities, but aspects of these considerations can apply to debt instruments, real estate, and other investments as well.

The list below of due diligence steps is not comprehensive since there are many types of securities in existence and as a result, many variations of due diligence that might be needed for a specific investment.

Also, it's important to consider risk tolerance when performing due diligence. There's no one-size-fits-all strategy for investors since investors might have different risk tolerance levels and investment goals. Retirees, for example, might look to an investment for dividend income and might place a higher value on more established companies while an investor seeking growth might place a higher value on capital investment and revenue growth. In other words, due diligence can result in different interpretations of the findings depending on who's performing the research.

Step 1: Analyze the Capitalization (Total Value) of the Company 

A company’s market capitalization can provide an indication of how volatile the stock price might be, how broad the ownership might be, and the potential size of the company's target markets.

For example, large-cap and mega-cap companies tend to have stable revenue streams and a large, diverse investor base, which can lead to less volatility. Mid-cap and small-cap companies, meanwhile, may only serve single areas of the market and typically have greater fluctuations in their stock price and earnings than large corporations.

The size and location of the company might also determine which exchange the stock is listed on or where it trades. You should also confirm whether the stock is listed on the New York Stock Exchange, Nasdaq, or if it's an American depositary receipt (ADRs), which means it'll have another listing on an exchange in another country. ADRs will typically have the letters "ADR" written in the title of the share listing.

Step 2: Revenue, Profit, and Margin Trends

In analyzing the numbers, the income statement will have the company's revenue or the top line, net income or profit, which is called the bottom line. It's important to monitor any trends in a company's revenue, operating expenses, profit margins, and return on equity.

Profit margin is calculated by dividing the company's net income by 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 perspective.

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 its competition. Every company is partially defined by its competition. As stated earlier, compare the profit margins of two or three competitors. Looking at the major competitors in each line of business (if there is more than one) may help you determine how competitive the company is in each market. Is the company a leader in its industry or the specific target markets? Is the industry growing?

Information about competitors can be found in company profiles on most major research sites, usually along with a list of certain metrics already calculated for you. Performing due diligence on multiple companies in the same industry can provide investors with enormous insight as to how the industry is performing and what companies have a leading edge over the competition.

Step 4: Valuation Multiples

There are many ratios and financial metrics that investors can use to evaluate companies. There's no one metric that's ideal for all investments, so it's best to utilize a combination of ratios to help generate a complete picture and lead to a more informed investment decision.

Some of the financial ratios include the price-to-earnings (P/E) ratio, price/earnings to growth (PEGs) ratio, and price-to-sales (P/S) ratio. As you calculate or research the ratios, compare the results to the company's competitors. You might find yourself becoming more interested in a competitor during this step, but still, look to follow through with the original pick.

P/E ratios can form the initial basis for the company's valuation. Earnings can and will have some volatility (even at the most stable companies). Investors should monitor valuations based on trailing earnings, or based on the last 12 months of earnings.

Basic "growth stock" versus "value stock" distinctions can be made, 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 earnings figures and P/Es to make sure that the current quarter or year isn't an aberration.

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 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. For some companies, their PEG ratio may be less than one, while others might have a PEG of 10 or higher. 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? Younger companies tend to be founder-lead companies. Research the consolidated bios of management to see their areas of focus or whether they have broad experience. Bio information can be located on the company's website.

Research if the founders and executives hold a high proportion of shares and whether they have been selling shares recently. Consider high ownership by top managers as a plus and low ownership a potential 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

Many articles could easily be devoted to just the balance sheet, but for our initial due diligence purposes, a cursory exam will suffice. The consolidated balance sheet will show the assets and liabilities as well as how much cash is available.

Also, monitor the level of debt and how that compares to companies in the industry. A lot of debt is not necessarily a bad thing, especially depending on the company's business model and industry. But what are agency ratings for its corporate bonds? Does the company generate enough cash to service its debt and pay any dividends?

Some companies (and industries as a whole) are very capital intensive like oil and gas companies while others require few fixed assets and capital investment. Determine the debt-to-equity ratio to see how much positive equity the company has going for it; you can then compare the findings with competitors. Typically, the more cash a company generates, the better an investment it's likely to be because it can service its debt and short-term obligations.

If the figures for total assets, total liabilities, and stockholders' equity change substantially from one year to the next, try to determine the reason. 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 happening with the company. The company 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 correlated 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 to certain investors.

Step 8: Stock Dilution Possibilities

Investors should know how many shares outstanding exist for the company and how that number relates to the competition. Is the company planning on issuing more shares or further diluting its share count? If so, the stock price might take a hit.

Step 9: Expectations

Investors should find out what the consensus of Wall Street analysts for earnings growth, revenue, and profit estimates are for the next two to three years. Investors should also research discussions of long-term trends affecting the industry and company-specific details 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 that exist. Are there outstanding legal or regulatory matters? Is there unsteady management?

Investors should keep a healthy game of devil's advocate going 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 or how about economic growth and inflation?

Once you've completed the steps outlined above, investors you should get a better sense of the company's performance and how it stacks up to the competition. From there you can develop your investment strategy.

Key Takeaways

  • Due diligence is an investigation or audit of a potential investment or product to confirm all facts, that might include the review of financial records.
  • Due diligence refers to the research done before entering into an agreement or a financial transaction with another party.
  • Investors perform due diligence before buying a security from a company. Due diligence can be used for mergers, start up investments, and researching hedge funds.

Due Diligence Basics for Startup Investments

When considering investing in a startup, follow the above-mentioned steps (where applicable). But here are some startup-specific moves, reflecting the high level of risk this sort of enterprise carries.

  • Include an exit strategy: More than 50% of startups fail within the first two years. Plan your divestment strategy to recover your funds should the business fail.
  • Consider entering into a partnership: Partners split the capital and risk among themselves resulting in less 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 market conditions. 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 that period. Furthermore, look at the growth plan of the business and evaluate whether it is viable.

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. In traditional M&A activity, an acquiring firm deploys risk analysts who perform due diligence by studying costs, benefits, structures, assets, and liabilities or more colloquially known 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, otherwise 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.

It is easy to quantify organizational data, so in planning acquisitions, corporations traditionally focused on the hard numbers. But the fact remains 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, more than 50% of them do, it is often because the human element is ignored. For example, one set of a productive workforce may do very well under existing leadership, but might suddenly struggle with an unfamiliar management style. Without soft due diligence, the acquiring company does not know if the target's firms employees will resent the fact they are bearing the brunt of a corporate cultural shift.

Contemporary business analysis calls this element "human capital." The corporate world starting 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 often 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, normally the target's projections, about future performance
  • Consumer market analysis
  • Operating redundancies and ease of eliminating them
  • Potential or ongoing litigation
  • Review of antitrust considerations
  • Evaluating subcontractor and other third-party relationships
  • Constructing and executing a disclosure schedule

Performing Soft Due Diligence

Conducting soft due diligence is not an exact science. Some acquiring firms treat it very formally, including it as an official stage of the pre-deal phase. Other firms are less targeted; they might spend more time and effort on the human resources side and have no defined criteria for success.

Soft due diligence should focus on how well a targeted workforce will mesh with the acquiring corporation's culture. If the cultures do not seem like an ideal fit, concessions might have to be made, which could include personnel decisions, particularly with top executives and other influential employees.

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 influence those motivations. It is not a panacea or a cure-all band-aid, 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 (actual or perceived) in service, products, procedures, or even names. This is why many M&A analyses now include customer reviews, supplier reviews, and test market data.

Due diligence refers to the research done before entering into an agreement or a financial transaction with another party.

Due Diligence for Financial Advisors

A financial advisor should be doing due diligence on funds or products they are interested in for clients. Researching any regulatory actions that may have taken place at an investment management firm. Advisors should also make sure to research whether or not an investment firm has been involved in any kind of lawsuits, including those that were settled outside of court.

Bankruptcy filings and criminal records can also be found in locations where a particular manager may reside or work and are another example of documents that should be reviewed. Clearly, they would serve as a red flag when considering whether or not to do business with this firm. Another important step to take is to verify the educational credentials of the manager.

Recommending a Fund

Looking at the performance history and track record of a manager’s funds is also a key part of the due diligence process. An advisor may even want to talk to various people working in other departments of the investment firm to get a sense of what has been happening there. This approach may help in learning about issues that may not be disclosed in the company’s literature.

Another key area to examine fully is the fund’s assets or holdings. It’s important to make sure that the investments in a fund are in line with similar funds or with its key benchmarks and that the fund is not invested outside of its mandate, as this will affect performance. Relying on due diligence provided by turnkey asset management programs can be useful, but advisers should still make sure to thoroughly review these programs to find out what they cover.

Meet with the Manager

If possible, speaking with a money manager can be helpful, particularly when the manager is investing in alternative products. Some investment vehicles, such as hedge funds, hold certain proprietary information or follow certain strategies that they are not required to disclose in written documents. In addition, advisers should be looking for any disciplinary history an investment firm has imposed on a manager and find out if the firm is willing to talk about it.