Due DiligenceDue Diligence

Due DiligenceDue Diligence

The process to purchase an asset are The process to purchase an asset are usually dependent on the results of due usually dependent on the results of due diligence analysis. This includes reviewing diligence analysis. This includes reviewing all financial records plus anything else all financial records plus anything else deemed material to the sale. Sellers could deemed material to the sale. Sellers could also perform a due diligence analysis on also perform a due diligence analysis on the buyer. Items that may be considered the buyer. Items that may be considered are the buyer's ability to purchase, as well are the buyer's ability to purchase, as well as other items that would affect the as other items that would affect the purchased entity or the seller after the purchased entity or the seller after the sale has been completed. sale has been completed.

Due Diligence made EasyDue Diligence made Easy

You sit down at your computer with a fresh You sit down at your computer with a fresh cocktail napkin or sticky note that has a cocktail napkin or sticky note that has a single ticker scribbled across it - it's a single ticker scribbled across it - it's a ticker you've never researched before, but ticker you've never researched before, but something (or someone) has piqued your something (or someone) has piqued your interest. This article will discuss 10 steps interest. This article will discuss 10 steps you should take on your first tour through you should take on your first tour through a new stock. This a new stock. This due diligencedue diligence allows you allows you to gain essential information and vet out a to gain essential information and vet out a possible new investment. possible new investment.

Step 1 - The Capitalization of the Step 1 - The Capitalization of the CompanyCompany

It really helps to form a mental It really helps to form a mental picture or diagram of a newly picture or diagram of a newly researched company and the first researched company and the first step is to determine just how big the step is to determine just how big the company is. The company is. The market capitalizationmarket capitalization says a lot about says a lot about how volatile the stock is likely to be, how volatile the stock is likely to be, how broad the ownership might be how broad the ownership might be and the potential size of the and the potential size of the company's end markets company's end markets

For example, For example, large caplarge cap and and mega capmega cap companies tend to have more stable companies tend to have more stable revenue streams and less volatility. revenue streams and less volatility. Mid capMid cap and and small capsmall cap companies, meanwhile, may companies, meanwhile, may only serve single areas of the market, and only serve single areas of the market, and may have more fluctuations in their stock may have more fluctuations in their stock price and earnings. (To learn more about price and earnings. (To learn more about market cap, see market cap, see Market Capitalization DefinedMarket Capitalization Defined and and Determining What Market Cap Suits Your StDetermining What Market Cap Suits Your Styleyle.) .)

Step 2 - Revenue, Profit and Step 2 - Revenue, Profit and Margin TrendsMargin Trends

When beginning to look at the numbers, it may be best to When beginning to look at the numbers, it may be best to start with the start with the revenuerevenue, , profitprofit and and marginmargin (RPM) trends. (RPM) trends.

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

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

Step 3 - Competitors and Industries

Compare the margins of two or three Compare the margins of two or three competitors. Every company is competitors. Every company is partially defined by who it competes partially defined by who it competes with. Looking at the major with. Looking at the major competitors in each line of business competitors in each line of business (if there is more than one) may help (if there is more than one) may help you nail down just how big the end you nail down just how big the end markets for products are. markets for products are.

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

Step 4 - Valuation Multiples

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

the PEG ratio brings into account the the PEG ratio brings into account the expectations for future earnings expectations for future earnings growth, and how it compares to the growth, and how it compares to the current earnings multiple. Stocks current earnings multiple. Stocks with PEG ratios close to 1 are with PEG ratios close to 1 are considered fairly valued under considered fairly valued under normal market conditions.normal market conditions.

Step 5 - Management and Share Ownership

Is the company still run by its founders? Or Is the company still run by its founders? Or has management and the board shuffled has management and the board shuffled in a lot of new faces? The age of the in a lot of new faces? The age of the company is a big factor here, as younger company is a big factor here, as younger companies tend to have more of the companies tend to have more of the founding members still around. Look at founding members still around. Look at consolidated bios of top managers to see consolidated bios of top managers to see what kind of broad experiences they have; what kind of broad experiences they have; this information may be found on the this information may be found on the company's website or on SEC filings.company's website or on SEC filings.

Also look to see if founders and managers Also look to see if founders and managers hold a high proportion of shares, and what hold a high proportion of shares, and what amount of the amount of the floatfloat is held by institutions. is held by institutions. Institutional ownershipInstitutional ownership percentages percentages indicate how much analyst coverage the indicate how much analyst coverage the company is getting as well as factors company is getting as well as factors influencing trade volumes. Consider high influencing trade volumes. Consider high personal ownership by top managers as a personal ownership by top managers as a plus, and low ownership a potential red plus, and low ownership a potential red flag. Shareholders tend to be best served flag. Shareholders tend to be best served when the people running the company when the people running the company have a stake in the performance of the have a stake in the performance of the stock stock

Step 6 - Balance Sheet Exam

Look up a consolidated balance sheet to Look up a consolidated balance sheet to see the overall level of assets and see the overall level of assets and liabilities, paying special attention to cash liabilities, paying special attention to cash levels (the ability to pay short-term levels (the ability to pay short-term liabilities) and the amount of long-term liabilities) and the amount of long-term debt held by the company. A lot of debt is debt held by the company. A lot of debt is not necessarily a bad thing, and depends not necessarily a bad thing, and depends more on the business model than anything more on the business model than anything else. Some companies (and industries as a else. Some companies (and industries as a whole) are very capital intensive, while whole) are very capital intensive, while others require little more than the basics others require little more than the basics of employees, equipment and a novel idea of employees, equipment and a novel idea to get up and running. to get up and running.

Look at the debt-to-equity ratio to Look at the debt-to-equity ratio to see how much positive equity the see how much positive equity the company has going for it; you can company has going for it; you can then compare this with the then compare this with the competitors to put the metric into competitors to put the metric into better perspective. better perspective.

Step 7 - Stock Price History

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

Step 8 - Stock Options and Dilution Possibilities

investors will need to dig into the investors will need to dig into the

10-Q and 10-K reports. Quarterly SEC 10-Q and 10-K reports. Quarterly SEC filings are required to show all filings are required to show all outstanding stock options as well as outstanding stock options as well as the conversion expectations given a the conversion expectations given a range of future stock prices. range of future stock prices.

Step 9 - Expectations

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

Step 10 - Risks

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

Once you've completed these steps you Once you've completed these steps you should be able to wrap your mind around should be able to wrap your mind around what the company has done so far, and what the company has done so far, and how it might fit into a broad portfolio or how it might fit into a broad portfolio or investment strategy. Inevitably you'll have investment strategy. Inevitably you'll have specifics that you will want to research specifics that you will want to research further, but following these guidelines further, but following these guidelines should save you from missing something should save you from missing something that could be vital to your decision that could be vital to your decision

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