In detail What is due diligence mean ?
Due diligence is a method of investigating, auditing or reviewing the performance that is confirming facts or details of a matter under consideration.
In the financial world, due diligence requires examining financial records before entering into a proposed transaction with another party.
Understanding the Due Diligence
Due diligence became common practice and also a common term in the United States under the Securities Act of 1933.
Under this law, securities dealers and brokers became those names who were responsible for fully disclosing material information about their selling instruments.
Failure in disclosing this information for potential investors made dealers and brokers liable for criminal prosecution.
The writers of this act recognized that the requirement of full disclosure left dealers and brokers vulnerable for unfair prosecution for failing for disclosing a material fact that they were not possessing or couldn’t to have been known at the any time of any sale.
Thus, the act can be included in a legal defense. As long as the dealers and brokers have exercised “due diligence” while investigating the companies whose equities were sold and have fully disclosed the results, they couldn’t hold their liable for information that wasn’t discovered during the time of the investigation.
Various types of Due Diligence to answer What is due diligence mean ?
Due diligence can be performed by equity research analysts, fund managers, broker-dealers, individual investors, and companies considering acquiring other companies.
Due diligence by individual investors can be voluntary. However, broker-dealers were legally obligated for conducting due diligence on security before selling it.
How to Perform Due Diligence for Stocks ?
Below are ten steps mentioned for individual investors who have undertaken due diligence.
Most have been related to stocks, but, in many cases, they can be applied to bonds, real estate, and many other investments.
After those ten steps, we will offer some tips while considering an investment as a startup company.
All of the details you need is readily available in the company’s quarterly and annual reports and the company profiles on sites of financial news and discount brokerage.
Step 1: Analyzing the Capitalization of the Company
A company’s market capitalization, or total value also indicates that how volatile the stock price can be, how broad its ownership can be, and the potential size of the company’s target markets.
Mega-cap and large-cap companies are tend to have stable revenue streams and a large, diverse investor base which was leading to less volatility.
Typically, Mid-cap and small-cap companies have greater fluctuations in their stock prices and earnings than any other larger corporations.
Step 2: Margin Trends, Revenue and Profit
The income statement of a company will be listed in its revenue or its net income or profit.
That will be the bottom line. It is also been important to mainly monitor trends over time in its operating expenses, revenue profit margins, and return on equity.
The company’s profit margin can be calculated by dividing its net income by its revenue.
It is also best to analyze profit margin over several quarters or years and compare those results with those companies within the same industry to gain some perspective.
Step 3: Competitors and Industries
Now that you have felt that how big the company is and how much it is earning, it is time for sizing up the industry in which it is operating and its competing.
Every company have been defined in part by its competition. The due diligence involves comparing the profit margins of a company with two or three of its competitors.
For example, questions are:
Is the company is the leader in its industry, or it is specified in target markets?
Is the company’s industry growing?
By performing due diligence on several companies in the same industry can give an investor a significant idea of how the industry is performing and which companies is having the leading edge in that industry.
Step 4: Valuation of Multiples
Many ratios and financial metrics are used for evaluating companies.
Still, three of the most useful are the price-to-earnings (P/E) ratio, the price/earnings to growth (PEGs) ratio, and the price-to-sales (P/S) ratio.
These ratios have been calculated already for you on some websites such as Yahoo! Finance.
As you are researching ratios for a company, comparing several of its competitors. You may find yourself that you are becoming more interested in a competitor.
The P/E ratio also gives you a general sense of how much expectation is needed to be built into the company’s stock price. It’s a good idea for examining this ratio over a few years for making sure that the current quarter is not an aberration.
The price-to-book (P/B) ratio, the enterprise can be multiplied, and the price-to-sales (or revenue) ratio measure its valuation concerning its debt, balance sheet and annual revenues. Here, Peer comparison is also important because the healthy ranges can differ from one industry to another industry.
The PEG ratio can suggests expectations among investors for the company’s future earnings growth and how it is compared with multiple current earnings.
PEG ratios stocks was close to one are considered as fairly valued under several normal market conditions.
Step 5: Management and Sharing Ownership
Is the company is still controlled by its founders, or has the board shuffled in many new faces? New companies tend to be founder-led.
Researching the bios of management for finding out their level of expertise and experience. Bio information can also been found on the company’s website.
The P/E ratio gives a view of the expectations that investors are having for the stock’s near-term performance.
Whether founders and executives are holding a high proportion of shares and whether they are recently selling shares is a significant factor in due diligence.
High ownership by top managers can be a plus, and low ownership can be a red flag. Shareholders also tend to be best served when those running the company have a vested interest in stock performance.
Step 6: Balance Sheet
The company’s consolidated balance sheet will also show its assets and liabilities and how much cash is available.
Checking the company’s level of debt and how it is able to compare to others in the industry.
Necessarily debt isn’t a bad thing, but it depends on the company’s business model and industry.
But it is also been important to make sure that those debts are highly rated by the rating agencies.
Some companies and industries, like petroleum, are very capital intensive, while others need a few fixed assets and capital investment.
Determination of the debt-to-equity ratio is to see how much positive equity the company is having.
Typically, the more money a company is generating, the better an investment it’s likely to be because it can meet its debts and still keep growing.
If the figures for total liabilities, total assets and stockholders’ equity change is substantially from one year till the next year. Try to figure out to know why. Reading the footnotes accompanying the financial statements and the management’s discussion in the quarterly or annual reports can shed light on what’s happening in a company. The firm could be preparing for a launch of a new product, accumulating retained earnings, or in a state of financial decline.
Step 7: Stock Price History
Investors should research both the stock’s short-term and long-term price movements and whether the stock would be having a volatile or steady.
By comparison, the profits are generated historically and determined that how it is correlating with the price movement.
By keeping in mind that past performance doesn’t guarantee about the future price movements.
If you’re a retiree and looking for dividends, for e.g., you might not want a stock price which is volatile. Stocks that are continuously volatile are tend to have short-term shareholders, adding additional risk for certain investors.
Step 8: Stock Dilution Possibilities
Investors should know that how many outstanding shares the company is having and how that number can relate to the competition.
Is the company is planning on issuing more shares? If so, then the stock price might take a hit.
Step 9: Expectations
Investors is needed to find out that what the consensus of Wall Street analysts is for earnings revenue, growth and profit which is estimated for the next 2 to 3 years.
Investors is needed to look for discussions of long-term trends which are affecting the industry and company-specific news about several partnerships, intellectual property, joint ventures, and new products or services.
Step 10: Examine Long and a Short-Term Risks
Be sure in order to understand both of the industry-wide risks and a company-specific risks. Are there is outstanding as legal or a regulatory matters? Is there is a unsteady management?
Investors should have to play advocate at all of times, picturing worst-case in a scenarios and their potential type of outcomes on the stock.
How would this affect the company if a new product fails or a competitor brings a new and better product forward? How there would be a jump in interest rates which would be affecting the company?
Once you have completed the steps which are outlined above, you’ll be having a better sense of the company’s performance and how it is stacking up to the competition. You will be better informed for making a sound decision.
Basics of Due Diligence for Startup Investments
When considering investment in a startup, some of the ten steps above are appropriate, while others aren’t possible because the company doesn’t have a track record. Here are some specific startup moves.
By including an exit strategy, more than 90% of startups breaks down. Plan a strategy for recovering your money should be the business fail.
Consider entering into a partnership condition: Partners also split the capital and risk, losing less if there is risk of business fails.
Figuring out the strategy of harvesting for your investment. Profitable businesses may also fail due to a change in government policy, technology, or market conditions. Be on the observation for new trends, technologies, and brands, and getting ready for harvesting when you find that any business may not have been thrive with the changes.
Choose a up a startup with good products. Since most investments have been harvested after five years, it is also advisable for investing in products that have an increased return on investment (ROI) for that period.
Instead of hard numbers on past performance, look at the business’s growth plan and evaluating whether it is appearing as a realistic.
Some special considerations for What is due diligence mean in M&A.
In the world of M&A (Mergers and Acquisitions), there is a delineation between “hard” and “soft” forms of due diligence.
In M&A activity, traditionally, the acquiring firm also deploy the risk to analysts who are performing due diligence by studying costs, benefits, assets, liabilities and structures.
Colloquially, that is known as hard due diligence.
However, increasingly 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 are driven by legalities and mathematics, is susceptible to rosy interpretations by impatient salespeople. Soft due diligence moves as a counterbalance when the numbers have being manipulated or overemphasized.
Numbers cannot fully capture many drivers of business success, such as relationship between employees, culture of corporation, and leadership. When M&A is dealing with fails, as more than 50% of them do, the human element is often ignored.
The modern business analysis calls this element as human capital. The corporate world start noticing its significance in the mid-2000s. In 2007, the Harvard Business Review have dedicated part of its April issue to “human capital due diligence,” warns that companies are ignoring it at their risk.
Hard performance of Due Diligence
In a deal of M&A, hard due diligence is the battlefield of lawyers, accountants, and negotiators.
In several fields such as technology or manufacturing, additional focus can be placed on intellectual property and physical capital.
Other examples of hard due diligence activities also includes:
- Review and Audit of financial statements.
- Scrutinize projections for future performance.
- Analysis of the consumer market.
- Seeking operating redundancies that have been eliminated.
- Review of potential or ongoing litigation.
- Review of antitrust considerations.
- Evaluation of subcontractor and other third-party relationships.
Soft performance of Due Diligence
Conducting soft due diligence is particularly not an exact science. It should be focused on how well a targeted workforce would be meshed with the acquiring culture of corporate.
Hard and soft due diligence can be intertwined when it comes to incentive compensation programs.
This kind of programs are not only based on real numbers, making them easy for incorporation into post-acquisition of planning, but they can also have been discussed with a employees and that used for gauging cultural impact.
Soft due diligence is concerned as the employee motivation, and specifically compensation packages are constructed for boosting those motivations is to answer What is due diligence mean ?.
It is not an elixir or a cure-all, but soft due diligence can be used for helping the acquired firm to predict whether a compensation program can be implemented for improving the success of a deal.
Soft due diligence can also be concerned itself by targeting company’s customers.
Even if the target employees are accepting the cultural and a operational shifts from the takeover. The target of customers and a clients that may well resent as a change in a service, a products, or a procedures. It is why many M&A analyses now include customer reviews, supplier reviews, and test market data.
My Name is Nadeem Shaikh the founder of nadeemacademy.com. I am a Qualified Chartered Accountant, B. com and M.Com. having professional and specialize experience in field of Account, Finance, and Taxation. Total experience of 20 years in providing businesses solution in Taxation, Accounting, and Finance with all statutory compliance with timely business performance Financials reports. You can contact me on [email protected] or [email protected]