Stock Due Diligence: A Guide for Beginners


Source Link: https://analyzingalpha.com/stock-due-diligence

A stock due diligence involves systematically investigating different factors impacting its future performance. 

If you are a beginner, this article is perfect for you. We will look into and conduct due diligence using a checklist that involves relevant questions about several fundamental aspects.

But before we dig into the checklist, let’s understand the basics.

What is stock due diligence?

Stock due diligence (DD) is a thorough investigation of the various elements that influence the performance of a potential investment in the stock market. It is vital because it helps investors take a calculated risk. When conducting stock due diligence, some of the factors taken into account are macro factors, risk assessment, market capitalization, industry scenario, and financial performance. 

Due diligence is done by fund managers, broker-dealers,  equity research analysts, and savvy retail investors. And when it comes to the stock market business, due diligence is the final step you will take before making a final investment decision.

Stock Due Diligence: The Checklist

Here is the stock due diligence checklist that includes the 16 most important questions that you must seek an answer to before you make a decision to buy.

1. How to Identify the stock?

The most important thing is to decide what stocks to buy. You can ask for advice from your friends or an analyst, but make sure you evaluate the motive behind their recommendations. Did they recommend it because they have a vested interest? Or did they recommend it to help you decide?

You can also identify the stock yourself. You can focus on a certain industry or sector to narrow down your choice.

2. Do you understand the business?

Before starting the business, you need to understand it first – how it works, how to manage it, how to earn, etc. If you are new to the market, start reading about the stocks you want to buy. It includes the company profile, background, how they earn money, and how it evolved over the years. The more you read, the more you know.

3. What Is The Market Capitalization Of The Target Company?

The market capitalization of the company measures its worth in the stock market. You can calculate market capitalization by adding the total market value of all outstanding shares. 

There are three categories when it comes to market cap, which include the following:

  • Small-cap companies: have a market capitalization of between 300 million and 2 billion
  • Mid-cap companies: have a market cap ranging from 2 billion to 10 billion
  • Large-cap companies: they have a market capitalization of at least $10 billion or more
4. How Strong Are The Company’s Financials?

Make sure to look into the income statement, balance sheet, and cash flow statement. Look into the financials, including the revenues and margin trends for the last five years. 

These questions should also be considered:

  • What is the primary source of income?
  • Are the cash from operations adequate to fund the expenditure?
  • What is the amount of working capital locked up in inventories?
  • What is the debtor cycle?

You must also look into the company’s debt-to-equity ratio and the off-balance sheet items, like contingent liabilities and inter-departmental debt.

5. How Strong Is The Management?

Part of the stock due diligence is looking into the background and professional credentials of the founders as well as the top management. What are their experiences and reputation in the industry? You can look up some of this information on the company website or on the Securities and Exchange Commission (SEC) filings.

6. How Attractive Is The Valuation?

When conducting due diligence, you need to look into the company’s valuation. It is best to look into the net profits over the past five to six years to assess whether the current earnings are consistent with the trends or a significant variation.

Some of the things to also look into are the following:

  • Price/Earnings growth ratio
  • Price to Book ratio
  • Price to Sales
  • Enterprise Value to EBITDA ratio

All these will show the company’s value against the company’s debt level, sales, and enterprise value.

7. What Are The Major Risk Elements?

Look into the company’s major risks. These include internal and external (industry and economy) risks. Is the company involved in a legal controversy? Is the management facing a lawsuit? Is the company offering ethical services to customers?

8. Is The Company Equipped To Respond To Macro Trends?

There are several factors that affect the company’s future. These include technological trends, industry trends, and new regulations. It is best to invest in a company that can respond to these factors effectively.

If you plan to buy stocks for long-term investment, make sure to check on how they will respond to any changes in the regulation as well as technological disruptions.

9. What Does The Stock Price History Indicate?

Looking into the price history of the stock you are planning to purchase will help you udnerstand the company’s current performance as well as the future course of movement. It is a smart move to look into the stock’s trading volume.

10. What Are The Future Projections?

One of the basic things to look into when conduction due diligence is the projections. Look into the industry-specific predictions as well as the industry reports, interviews of CEOs, analyst estimates and market projections.

11. How Strong Is Corporate Governance?

The corporate governance refers to the set of rules, controls, policies, and resolutions. You should check if the management’s interests are aligned to yours. Good corporate governance sets transparent rules and these rules should aligned to the principles of the shareholders, directors and officers.

In any kind of business, being profitable is not the only things that matter, the company also needs to a good corporate citizen.

12. How Steady Is The Return on Equity Growth?

It is also important to check the company’s Return of Equity (ROE). If the ROE is more than the cost of equity, then the company is adding value for you.

13. What Are The Long-Term Goals?

If you are doing due diligence, do not forget to look into the company’s long-term goals. The goals should align to your own long-term financial goals. If you think that it adds risk to you, they you should not have it in your portfolio.

14. What Are The Company’s Competitive Advantages?

Company‚Äôs competitive advantage must include the pricing power and brand name. It must allow the company to have a sustainable business with long-term profits. 

It would also help if you read information about the company’s competitors. This way, you can identify what’s unique with the company and how they perform compared to others.

15. How Effective Are The Labor And Personnel Relation?

With no doubt, you should consider investing in a company with a highly qualified and efficient research-and-development (R&D) team. Companies with great R&D are progressive. However, you need to also look the sales and R&D expense ration.

16. What Steps Does The Company Take To Safeguard Or Boost Profit Margins?

You must pay close attention to the cost-reduction and profit-maximization strategies of the company. It is ideal if the company conducts a periodic review of its operational costs and controls it to boost profit.

Conclusion

When conducting due diligence, you should focus on getting important information that will help you make fundamental decisions. If you feel the stock won’t add value to your investment, drop it and pick another one.

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