What is ‘Due Diligence’

Due diligence is an investigation or audit of a potential investment or product to confirm all facts, such as reviewing all financial records, plus anything else deemed material. It refers to the care a reasonable person should take before entering into an agreement or a financial transaction with another party. Due diligence can also refer to the investigation a seller does of a buyer; items that may be considered are whether the buyer has adequate resources to complete the purchase, as well as other elements that would affect the acquired entity or the seller after the sale has been completed.

In the investment world, due diligence is performed by companies seeking to make acquisitions, by equity research analysts, by fund managers, broker-dealers, and of course by investors. For individual investors, doing due diligence on a security is voluntary, but recommended. Broker-dealers, however, are legally obligated to conduct due diligence on a security before selling it. This prevents them from being held liable for non-disclosure of pertinent information.

BREAKING DOWN ‘Due Diligence’

Due diligence became common practice (and a common term) in the U.S. with the passage of the Securities Act of 1933. Securities dealers and brokers became responsible for fully disclosing material information related to the instruments they were selling. Failing to disclose this information to potential investors made dealers and brokers liable for criminal prosecution. However, creators of the Act understood that requiring full disclosure left the securities dealers and brokers vulnerable to unfair prosecution if they did not disclose a material fact they did not possess or could not have known at the time of sale. As a means of protecting them, the Act included a legal defense that stated that as long as the dealers and brokers exercised “due diligence” when investigating companies whose equities they were selling, and fully disclosed their results to investors, they would not be held liable for information not discovered during the investigation.

A standard part of an initial public offering is the due diligence meeting, a process of careful investigation by an underwriter to ensure that all material information pertinent to the security issue has been disclosed to prospective investors. Before issuing a final prospectus, the underwriter, issuer and other individuals involved (such as accountants, syndicate members, and attorneys),will gather to discuss whether the underwriter and issuer have exercised due diligence toward state and federal securities laws.

The Due Diligence Process

Below are detailed steps for individual investors undertaking due diligence. Most are related to equities, but aspects of these considerations can apply to debt instruments, real estate and other investments as well.

Step 1: Analyze the Capitalization (Total Value) of the Company

The first step: determine just how big the company is. The company’s 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. For example, large cap and mega cap companies tend to have more stable revenue streams and a large more diverse investor base, both of which generally equate to less volatility. Mid cap and small cap companies, meanwhile, may only serve single areas of the market, and may have more fluctuations in their stock price and earnings. When you start to examine revenue and profit figures, the market cap will give you some perspective.

Conversely, the largest, most expensive real estate in any market is generally less liquid than more average-priced properties.

You should also confirm one other vital fact on this first check: What stock exchange do 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 (ADRs) with another listing on a foreign exchange? ADRs will typically have the letters “ADR” written somewhere in the reported title of the share listing. This information along with market cap should help answer basic questions like whether you can own the shares in your current investment accounts.

Step 2: Revenue, Profit, and Margin Trends

When beginning to look at the numbers, it may be best to start with the revenue and profit margin (RPM) trends. Understanding a company’s gross revenue, profit margins and return on equity and whether it is growing or shrinking is essential in any equity or corporate bond investment.

Look up the revenue and net income trends for the past two years at a general finance website. These should have links to quarterly (for the past 12 months) and annual reports (past two to three years). Look at the recent trends in both sets of figures, noting whether growth is choppy or consistent, or if there any major swings (such as more than 50% in one year) in either direction.

Profit margins should also be reviewed to see if they are generally rising, falling, or remaining the same. Some investors demand that a company’s return on equity plus its profit margins be equal to 50 or greater – the higher the better. This information will come into play more during the next step.

Step 3: Competitors and Industries

Now that you have a feel for how big the company is and how much money it earns, it’s time to size up the industries it operates in and who it competes with. Every company is partially defined by its competition. Compare the margins of two or three competitors. Looking at the major competitors in each line of business (if there is more than one) may help you nail down just how big the end markets for products are. Is the company a leader in its industry? Is its industry growing overall, and could its position in the field change?

Information about competitors can be found in company profiles on most major research sites, usually along with a list of certain metrics filled in for both the company you’re researching and its competitors. If you’re still uncertain of how the company’s business model works, you should look to fill in any gaps here before moving further along. Sometimes just reading about some of the competitors may help to…