Due Diligence

What Is Due Diligence?

Due diligence is an investigation, audit, or review performed to confirm facts or details 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.

KEY TAKEAWAYS

Due diligence is a systematic way to analyse and mitigate risk from a business or investment decision.
An individual investor can conduct due diligence on any stock using readily available public information.
The same due diligence strategy will work on many other types of investments.
Due diligence involves examining a company’s numbers, comparing the numbers over time, and benchmarking them against competitors.
Due diligence is applied in many other contexts, for example, conducting a background check on a potential employee or reading product reviews.

Understanding Due Diligence

Due diligence became common practice (and a common term) in the United States 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 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.

Due diligence is performed by equity research analysts, fund managers, broker-dealers, individual investors, and companies that are considering acquiring other companies. Due diligence by individual investors is voluntary. However, broker-dealers are legally obligated to conduct due diligence on a security before selling it.

Types of Due Diligence

Depending on its purpose, due diligence takes different forms.

Context-Specific Due Diligence

Commercial due diligence considers a company’s market share and competitive positioning, including its future prospects and growth opportunities. This will consider the company’s supply chain from vendors to customers, market analysis, sales pipeline, and R&D pipeline. This can also encompass a firm’s overall operations, including management, human resources, and IT.
Legal due diligence makes sure that a company has all of its legal, regulatory, and compliance eggs in a row. This includes everything from pending litigation to intellectual property rights to being sure the company was properly incorporated
Financial due diligence audits a company’s financial statements and books to make sure that there are no irregularities and that the company is on solid financial footing.
Tax due diligence looks at the company’s tax exposure, whether it may owe any back taxes, and where it can reduce its tax burden going forward.

Hard vs. Soft Due Diligence

Due diligence can be categorized as “hard” or “soft” based on the approach used.

Hard due diligence is concerned with the numbers and data found on the financial statements like the balance sheet and income statement. This can entail fundamental analysis and the use of financial ratios to get a grasp on a company’s financial position and make projections into the future. This type of due diligence can also identify red flags or accounting inconsistencies however, 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.
Soft due diligence is a more qualitative approach that looks at aspects such as the quality of the management, the people within the company, and the loyalty of its customer base. There are indeed many drivers of business success that numbers cannot fully capture, such as employee relationships, corporate culture, and leadership. When M&A deals fail, as an estimated 70%-90% of them do, it is often because the human element is ignored.

We discuss more on how these two types of due diligence are put into practice in the context of M&A deals below.

How to Perform Due Diligence for Stocks

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, we offer some tips when 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 and 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 in which it operates and its competition. Every company is defined in part by its competition. Due diligence involves comparing the profit margins of a company with two or three of its competitors. For example, questions to ask are: Is the company a leader in its industry or its specific target markets? Is the company’s industry growing?

Performing due diligence on several companies in the same industry can give an investor significant insight into how the industry is performing and which companies have the leading edge in that industry.

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. These ratios are 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.

Whether founders and executives hold a high proportion of shares and whether they have been selling shares recently is a significant factor in due diligence. 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 stock performance.

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 because the company can 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 a company. The firm 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 movements 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 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 play 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 will be better informed 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. 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.

M&A Due Diligence

In the mergers and acquisitions (M&A) world, a company that is considering a deal will perform a financial analysis on a target company. The due diligence might also include an analysis of future growth. The acquirer may ask questions that address the structuring of the acquisition. The acquirer is also likely to look at the current practices and policies of the target company and perform a shareholder value analysis.

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 via soft due diligence.

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.

What Exactly Is Due Diligence?

Due diligence is a process or effort to collect and analyze information before making a decision. It is a process often used by investors to assess risk. It involves examining a company’s numbers, comparing the numbers over time, and benchmarking them against competitors to assess an investment’s potential in terms of growth.

What Is the Purpose of Due Diligence?

Due diligence is primarily a way to reduce exposure to risk. The process ensures that a party is aware of all the details of a transaction before they agree to it. For example, a broker-dealer will give an investor the results of a due diligence report so that the investor is fully informed and cannot hold the broker-dealer responsible for any losses.

What Is a Due Diligence Checklist?

A due diligence checklist is an organized way to analyze a company. The checklist will include all the areas to be analyzed, such as ownership and organization, assets and operations, the financial ratios, shareholder value, processes and policies, future growth potential, management, and human resources.

What Is a Due Diligence Example?

Examples of due diligence can be found in many areas of our daily lives. For example, conducting a property inspection before completing a purchase to assess the risk of the investment, an acquiring company that examines a target firm before completing a merger or acquisition, and an employer performing a background check on a potential recruit.

The Bottom Line

Due diligence is a process or effort to collect and analyze information before making a decision or conducting a transaction so a party is not held legally liable for any loss or damage. The term applies to many situations but most notably to business transactions. Due diligence is performed by investors who want to minimize risk, broker-dealers who want to ensure that a party to any transaction is fully informed of the details so that the broker-dealer is not held responsible, and companies who are considering acquiring another firm. Fundamentally, doing your due diligence means that you have gathered the necessary facts to make a wise and informed decision.