Due Diligence in 10 Easy Steps

Due diligence is the investigation of a product or a potential investment such as a stock to confirm all facts. It can include reviewing all financial records and past company performance plus anything else that’s deemed material. Performing due diligence on a potential stock investment is voluntary but recommended for individual investors.

The steps are organized so you’ll build upon what you previously learned with each new piece of information.

Key Takeaways

• Due diligence is an investigation of a potential investment such as a stock to confirm all facts and ensure that the purchase will meet the buyer’s needs.
• You should consider a variety of factors when performing due diligence on a stock including company capitalization, revenue, valuations, competitors, management, and risks.
• You’ll be better equipped to make a decision that aligns with your overall investment strategy by taking the time to perform due diligence on a stock before making a purchase,
• There will probably be specifics that you’ll want to research further after you complete these steps.

Step 1: Company Capitalization

The first step is to form a mental picture or diagram of the company you’re researching. You’ll want to look at the company’s market capitalization which shows you just how big the company is by calculating the total dollar market value of its outstanding shares.

The market capitalization says a lot about how volatile the stock is likely to be, how broad the ownership might be, and the potential size of the company’s end markets. Large-cap and mega-cap companies tend to have more stable revenue streams and less volatility. Mid-cap and small-cap companies may only serve single areas of the market and may have more fluctuations in their stock price and earnings. 

You’re not making any judgments regarding the stock at this step in due diligence. You should focus your efforts on accumulating information that will set the stage for everything to come. The information you’ve gathered about the company’s market capitalization will give you some perspective when you start to examine revenue and profit figures.

You should also confirm the stock exchange the shares trade on. Are they based in the United States such as the New York Stock Exchange, Nasdaq, or over the counter? Or are they American depositary receipts with another listing on a foreign exchange? American depository receipts will typically have the letters “ADR” written somewhere in the reported title of the share listing.

Along with market cap, this information should help answer basic questions, such as whether you can own the shares in your current investment accounts.

Step 2: Revenue, Margin Trends

It may be best to start with the revenue, profit, and margin trends when you begin looking at the financial numbers related to the company you’re researching. Look up the revenue and net income trends for the past two years at a financial news site that allows you to easily search for detailed company information using the company name or ticker symbol.

These sites provide historical charts that show a company’s price fluctuations over time. They’ll also give you the price-to-sales (P/S) ratio and the price-to-earnings (P/E) ratio. Look at the recent trends in both sets of figures. Note whether growth is choppy or consistent or if there are any major swings such as more than 50% in one year in either direction.

You should also review profit margins to see if they’re generally rising, falling, or remaining the same. You can find specific information regarding profit margins by going directly to the company’s website and searching their investor relations section for their quarterly and annual financial statements.

Step 3: Competitors and Industries

Now it’s time to size up the industries it operates in and with whom it competes. Compare the margins of two or three competitors. Every company is partially defined by them. You may be able to determine how big the end markets are for its products just by looking at the major competitors in each line of the company’s business if there’s more than one.

You can find information about the company’s competitors on most major stock research sites. You’ll usually find the ticker symbols of your company’s competitors along with direct comparisons of certain metrics for both the company you’re researching and its competitors. 

Look to fill in any gaps here before moving forward if you’re still uncertain about how the company’s business model works. Sometimes just reading about competitors may help you understand what your target company does.

Step 4: Valuation Multiples

Now it’s time to get to the nitty-gritty of performing due diligence on a stock. You’ll want to review the price/earnings to growth (PEG) ratio for both the company you’re researching and its competitors. Make a note of any large discrepancies in valuations between the company and its competitors.

P/E ratios can form the initial basis for looking at valuations. Earnings can and will have some volatility even at the most stable companies but valuations based on trailing earnings or current estimates are a yardstick that allows instant comparison to broad market multiples or direct competitors.

You’ll probably begin to get an idea if the company is a “growth stock” versus a “value stock” at this point. You should also have a general sense of how profitable the company is. It’s generally a good idea to examine a few years’ worth of net earnings figures to make sure the most recent earnings figure and the one used to calculate the P/E is normalized and not being thrown off by a large one-time adjustment or charge.

The P/E should be looked at in conjunction with the price-to-book (P/B) ratio, the enterprise multiple, and the price-to-sales or revenue ratio. These multiples highlight the valuation of the company as it relates to its debt, annual revenues, and balance sheet. Ranges in these values differ from industry to industry so reviewing the same figures for some competitors or peers is a key step.

The PEG ratio brings into account the expectations for future earnings growth and how it compares to the current earnings multiple.

Important

Stocks with PEG ratios close to one are considered fairly valued under normal market conditions.

Step 5: Management and Ownership

You’ll want to answer some key questions regarding the company’s management and ownership. Is the company still run by its founders or has management and the board shuffled in a lot of new faces? The age of the company is a big factor here because younger companies tend to have more of the founding members still around.

Look at consolidated bios of top managers to see what kind of broad experiences they have. You can find this information on the company’s website or in its Securities and Exchange Commission (SEC) filings.

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

Step 6: Balance Sheet Exam

Review your company’s consolidated balance sheet to see the overall level of assets and liabilities. Pay special attention to cash levels and the ability to pay short-term liabilities as well as the amount of long-term debt held by the company. A lot of debt isn’t necessarily a bad thing. It depends more on the company’s business model than anything else.

Some companies and industries as a whole are very capital-intensive. Others require little more than the basics of employees, equipment, and a novel idea to get up and running. Look at the debt-to-equity ratio to see how much positive equity the company has. You can then compare this with the competitors’ debt-to-equity ratios to put the metric into a better perspective.

Try to determine the reason if the “top line” balance sheet figures of total assets, total liabilities, and stockholders’ equity change substantially from one year to the next. Reading the footnotes that accompany the financial statements and the management’s discussion in the quarterly/annual report can shed some light on the situation. The company could be preparing for a new product launch, accumulating retained earnings, or simply whittling away at precious capital resources.

What you see should start to have some deeper perspective after having reviewed the recent profit trends.

Step 7: Stock Price History

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

Step 8: Stock Options and Dilution

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

Use this information to help understand how the share count could change under different price scenarios. Stock options are potentially a powerful motivator for retaining employees but watch out for shady practices like the reissuing of “underwater” options or any formal investigations that have been made into illegal practices like options backdating.

Step 9: Expectations

This due diligence step requires some extra digging. You’ll want to find out what the consensus revenue and profit estimates are for the next two to three years. Look into long-term trends affecting the industry and company-specific details about partnerships, joint ventures, and intellectual property. Check for new products and services.

News about a product or service on the horizon may be what initially interested you in the stock. Now’s the time to examine it more fully with the help of everything you’ve accumulated so far.

Step 10: Risks

Make sure you understand both industry-wide risks and company-specific ones. Are there outstanding legal or regulatory matters? Is management making decisions that lead to an increase in the company’s revenues? Is the company eco-friendly? What kind of long-term risks could result from it embracing or not embracing green initiatives?

Investors should keep a healthy devil’s advocate mindset at all times, picturing worst-case scenarios and their potential outcomes on the stock.

How Is Market Capitalization Calculated?

Market capitalization is a company’s outstanding shares multiplied by the day’s stock price. This tells you the total value of all outstanding shares. It’s a quick and reasonably reliable indication of the company’s value.

What Is a Growth Stock?

A growth stock is one with a growth rate that’s significantly higher than that of the market in general. It will most likely earn you money more quickly than average.

What Is Options Backdating?

Options backdating is the process of granting options, typically to staff and employees, based on a date when their value was less than the current share price. These individuals therefore collect an immediate return. It’s not illegal but the matter has found its way to court on numerous occasions.

The Bottom Line

You should be able to evaluate the company’s future profit potential and how the stock might fit into your portfolio or investment strategy after you’ve completed these steps. You’ll inevitably have specifics that you’ll want to research further. Following these guidelines should save you from missing something that could be vital to your decision, however.

Veteran investors will throw many more investment ideas into the trash bin than they’ll keep for further review so never be afraid to start over with a fresh idea and another company. There are tens of thousands of companies out there to choose from.

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