What is due diligence?
Due diligence is a term referring to the research undertaken by a party involved in a potential investment or financial transaction. Its purpose is to check the correctness and reliability of the data provided during initial negotiations from the other party/parties involved in a negotiation.
The history of due diligence
Due diligence became common practice (and a common term) in the USA after the passing of the 1933 Securities Act. It meant that – in both civil and criminal law – securities traders and brokers became responsible for providing full information relating to the stock they were selling.
As a result, in order to avoid liability, traders and brokers had to use so-called due diligence, investigate the companies whose shares they were selling and share the results with investors.
The due diligence process
In finance, due diligence is undertaken by companies interested in making acquisitions, share analysts, fund managers, broker-dealers and investors. While due diligence is voluntary for investors, broker-dealers are legally obliged to carry out the necessary research on a share before selling it. This helps to prevent problems deriving from failure to divulge relevant information.
There are various phases to the due diligence process. Below are the various stages involved in the share purchase process, but some of these points can also be applied to debt instruments, real estate, and other investments.
This list of the phases of due diligence is not exhaustive, given that there are lots of types of shares in existence, which means that there could be lots of variations necessary for a specific investment. Furthermore, there is no set strategy for all investors because different investors may have different levels of tolerance to financial risk and different investment objectives. In other worse, depending on the circumstances and the interpretation criteria put in place, due diligence can lead to different results.
Step 1: analyzing the capitalization (total value) of the company
The market capitalization of a company can provide an indication of its share price volatility, the scope of ownership and the potential size of the company’s target markets.
For example, large-cap companies tend to have stable income streams and a wide, diversified investor pool, resulting in reduced volatility. Mid-cap and small-cap companies, meanwhile, may only serve specific areas of the financial industry and see bigger fluctuations in share price and profits than bigger companies.
The size and location of companies can also determine which stock exchange their shares are listed on or traded.
Step 2: analyzing income, profit, and margins
It’s important to monitor the flow of income, operating costs, profit margins and return on capital of a company.
The profit margin is calculated by dividing net profits by revenues. It is preferable to analyze the profit margin over a period of quarters or years and to compare these results with companies in the same sector in order to gain perspective.
Step 3: analyzing competitors and sectors
After the size and income of a company have been analyzed, it’s time to look at the sectors it operates in and its competitors. Looking at the main competitors in each sector (if more than one) can give an indication of the competitiveness of the company in each market. Is the company the leading company in its sector or in specific target markets? Is the industry growing?
Analyzing several companies in the same sector can provide investors with an in-depth picture of performance in the sector and of which companies have an advantage over the opposition.
Step 4: other considerations
There are many financial indicators and metrics that investors can use to assess companies. There is no one perfect metric for all investments, so it’s better to use a combination of different reporting tools to build up a comprehensive picture and take a more informed investment decision.
Some financial indicators include the price/earnings ratio (P/E), the price/earnings to growth ratio (PEG) and the price/sales ratio (P/S). When calculating or investigating the ratios, it’s good to compare results with the company’s competitors.
Earnings can be volatile (even in more stable companies). Investors should monitor valuations based on profits or in the last 12 months of earnings. Generally speaking, it’s a good idea to examine several years’ data on earnings and profits in order to ensure that a particular quarter or year isn’t an anomaly.
Step 5: management and sharing of ownership
Is the company still managed by its founders? Or is the leadership team or board made up of lots of new faces? It’s a good idea to look into the management team in order to gauge their areas of interest and see how much experience they have.
Consider whether the founders or directors own a high percentage of the shares or have sold shares recently. Generally speaking, it is considered positive when the company is mainly owned by its founder.
Step 6: analyzing the financial statement
The consolidated financial statement will show the company’s assets and liabilities and the liquidity available. It’s also a good idea to check if the company has debt and to compare this with other companies in the sector. High levels of debt are not necessarily a bad thing, especially for some business models or sectors. But what are the agency ratings for a company’s corporate bonds? Is the company generating enough liquidity to repay its debt and pay dividends?
Some companies (and industries as a whole) have a lot of capital, such as oil and gas companies, while others do not require extensive fixed assets or capital investment. It’s important to establish the debt to net worth ratio and then compare this with competitors and other sector parameters in order to assess the overall health of a company and the level of risk associated with any operation.
If data referring to the assets, liabilities and net worth of a company change significantly between one year and another, it’s a good idea to find out why. It may also be wise to read the footnotes in the financial statement.
Notice: This article is mainly focused on the Italian market and on other leading markets. We advise that readers check the data and regulations pertaining to their countries.