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 analyze 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 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 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 considering acquisitions. 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, competitive positioning, future prospects, and growth opportunities. This encompasses the company’s supply chain, market analysis, sales pipeline, R&D pipeline, management, human resources, and IT.
- Legal due diligence ensures a company has all necessary legal, regulatory, and compliance measures in place, from pending litigation to intellectual property rights.
- Financial due diligence audits a company’s financial statements and books to ensure there are no irregularities and that the company is financially sound.
- Tax due diligence examines the company’s tax exposure, liabilities, and opportunities for tax burden reduction in the future.
Hard vs. Soft Due Diligence
- Hard due diligence is focused on quantitative aspects such as financial statements, fundamental analysis, and financial ratios. It identifies accounting inconsistencies and assesses the company’s financial position. However, it can be susceptible to bias if salespeople overemphasize favorable data.
- Soft due diligence is qualitative and assesses management quality, corporate culture, employee loyalty, and customer base. This approach addresses drivers of business success beyond financial numbers. Failures in M&A deals often stem from neglecting these human elements.
We discuss how these types of due diligence are put into practice in the context of M&As below.
How to Perform Due Diligence for Stocks
Below are 10 steps for individual investors undertaking due diligence. Most are related to stocks but also applicable to bonds, real estate, and many other investments.
Step 1: Analyze the Capitalization of the Company
A company’s market capitalization indicates stock price volatility, ownership breadth, and potential market size.
- Large-cap and mega-cap companies have stable revenues and a diverse investor base, resulting in less volatility.
- Mid-cap and small-cap companies typically experience more significant fluctuations in stock prices and earnings.
Step 2: Revenue, Profit, and Margin Trends
Monitor trends over time in a company’s revenue, operating expenses, profit margins, and return on equity. Analyze these metrics over several quarters or years and compare them to industry peers for perspective.
Step 3: Competitors and Industries
Analyze the company’s industry and competition. Assess whether it is a leader or a follower in its industry and whether its sector is growing. Comparisons provide insights into performance and competitive advantage factors.
Step 4: Valuation Multiples
Utilize ratios such as P/E ratio, PEG ratio, and P/S ratio to evaluate companies. Peer comparisons reveal valuation insights. Stocks with PEG ratios close to one are considered fairly valued under normal market conditions.
Step 5: Management and Share Ownership
Evaluate if the company is still founder-led or has new management. Investigate management expertise and experience. Consider share ownership by management, as higher ownership often aligns their interests with investors.
Step 6: Balance Sheet
Assess the company’s balance sheet, including assets, liabilities, and debt levels. Determine its debt-to-equity ratio and cash flow generation, which are critical for meeting obligations and growth potential. Read financial footnotes and management discussions for additional context.
Step 7: Stock Price History
Review short-term and long-term stock price movements and volatility. Historical performance helps correlate with profit generation, although past performance isn’t always indicative of future pricing.
Step 8: Stock Dilution Possibilities
Understand the number of shares outstanding and potential future issuance. Plan for potential stock price impacts due to dilution.
Step 9: Expectations
Investigate the consensus for earnings growth, revenue, and profit estimates from analysts. Examine long-term industry trends and company-specific developments like partnerships, intellectual property, and new products.
Step 10: Examine Long and Short-Term Risks
Identify industry-wide and company-specific risks. Consider legal, regulatory, and management stability risks. Play devil’s advocate to assess worst-case scenarios and their potential outcomes.
Conclusion:
Finally, you’ll have a better sense of the company’s performance and its competitive positioning for making sound investment decisions.
Due Diligence Basics for Startup Investments
When considering investing in a startup, fitting due diligence steps apply while others may not be feasible. Here are startup-specific considerations:
- Include an exit strategy: Plan a mechanism to recover investment if the business fails.
- Consider partnerships: Sharing capital and risks limits losses if business struggles.
- Figure out the harvest strategy: Always be ready to exit if the investment ceases to be viable.
- Prioritize promising products: Invest in startups with products that offer increasing ROI.
- Evaluate growth plans: Assess whether the business growth plan is feasible and realistic given the absence of hard historical data.
M&A Due Diligence
Performing Hard Due Diligence
In M&As, hard due diligence involves accountants and lawyers performing tasks such as:
- Reviewing and auditing financial statements
- Scrutinizing projections for future performance
- Analyzing the consumer market
- Seeking operating redundancies
- Reviewing litigation risks
- Assessing antitrust concerns
- Evaluating subcontractor relationships
Performing Soft Due Diligence
Soft due diligence assesses qualitative elements such as:
- Employee motivation, matching compensation, and incentive programs effectively.
- Cultural alignment, ensuring a good fit between target and acquiring companies.
- Customer reviews and market data for understanding customer reactions post-acquisition.
Soft due diligence helps predict cultural and operational cohesiveness and customer retention post-takeover. The goal in both hard and soft due diligence is ensuring a seamless, value-generating acquisition.
Recap: What Exactly Is Due Diligence?
Due diligence involves gathering and analyzing information to make informed and risk-assessed decisions, primarily aimed at growth potential assessment.
Purpose
The main goal is to reduce risk exposure, ensuring informed decision-making to avoid future liabilities.
Checklist
A due diligence checklist typically includes analyzing ownership, financial metrics, operations, shareholder value, future growth plans, among other aspects.
Examples
Examples include property inspections, corporate mergers, background checks, each aiming to verify and mitigate risks.
The Bottom Line
Due diligence, fundamentally, is about gathering necessary facts for wise, informed decision-making. Whether in investments, acquisitions, or everyday transactions, diligent examination of all relevant information and comparing it to industry benchmarks underlies successful, risk-mitigated decisions.
Related Terms: Financial Analysis, Risk Management, Investment Strategies, Commercial Due Diligence, Mergers and Acquisitions.
References
- Govinfo.gov. “Securities Act of 1933”.
- Harvard Business Review. “Don’t Make This Common M&A Mistake”.
- Business Harvard Review. “Human Due Diligence”.
