Due diligence
Due diligence is a relatively common term. Used in business, it broadly refers to the process of investigating and verifying information about a company or investment opportunity. Specifically for compliance teams, it comes up when you consider relationships with new vendors and third parties. Yet it can be difficult to understand what due diligence really is and how best to incorporate it into your procedures. The dictionary gives the term ‘due diligence’ a basic meaning. Depending on the context in which the term is used, it can hold other meanings — especially for corporations, nonprofits and educational institutions. Due diligence as it pertains to business. The definition cites ‘research and analysis of a company or organization done in preparation for a business transaction (such as a corporate merger or purchase of securities).’ 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. Due diligence became common practice (and a common term) in the United States 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.1 The writers of the act recognized that requiring full disclosure left dealers and brokers vulnerable to unfair prosecution for failing to disclose a material fact they did not possess or could not have known at the time of sale. Thus, 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 that are considering acquiring other companies. 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 Commercial due diligence considers a company’s market share and competitive positioning, including its future prospects and growth opportunities. This will consider the company’s supply chain from vendors to customers, market analysis, sales pipeline, and R&D pipeline. This can also encompass a firm’s overall operations, including management, human resources, and IT. Legal due diligence makes sure that a company has all of its legal, regulatory, and compliance eggs in a row. This includes everything from pending litigation to intellectual property rights to being sure the company was properly incorporated Financial due diligence audits a company’s financial statements and books to make sure that there are no irregularities and that the company is on solid financial footing. Tax due diligence looks at the company’s tax exposure, whether it may owe any back taxes, and where it can reduce its tax burden going forward. Hard vs. Soft Due Diligence Due diligence can be categorized as “hard” or “soft” based on the approach used. Hard due diligence is concerned with the numbers and data found on the financial statements like the balance sheet and income statement. This can entail fundamental analysis and the use of financial ratios to get a grasp on a company’s financial position and make projections into the future. This type of due diligence can also identify red flags or accounting inconsistencies however, Hard due diligence, which is driven by mathematics and legalities, is susceptible to rosy interpretations by eager salespeople. Soft due diligence acts as a counterbalance when the numbers are being manipulated or overemphasized. Soft due diligence is a more qualitative approach that looks at aspects such as the quality of the management, the people within the company, and the loyalty of its customer base. There are indeed many drivers of business success that numbers cannot fully capture, such as employee relationships, corporate culture, and leadership. When M&A deals fail, as an estimated 70%-90% of them do, it is often because the human element is ignored How to Perform Due Diligence for Stocks Step 1: Analyze the Capitalization of the Company – A company’s market capitalization, or total value, indicates how volatile the stock price is, how broad its ownership is, and the potential size of the company’s target markets.Large-cap and mega-cap companies tend to have stable revenue streams and a large, diverse investor base, which tends to lead to less volatility. Mid-cap and small-cap companies typically have greater fluctuations in their stock prices and earnings than large corporations. Step 2: Revenue, Profit, and Margin Trends- The company’s income statement will list its revenue or its net income or profit. That’s the bottom line. It’s important to monitor trends over time in a company’s revenue, operating expenses, profit margins, and return on equity. The company’s profit margin is calculated by dividing its net income by its revenue. It’s best to analyze profit margin over several quarters or years and compare those results to companies within the same industry to gain some perspective. Step 3: Competitors and Industries- Now that you have a feel for how big the company is and how much it earns, it’s time to size up the industry in which it operates and its competition. Every company is defined in part by its competition. Due diligence involves comparing the profit margins of a company with two or three of its competitors. For example, questions to ask are: Is the company a leader in its industry or its specific target markets? Is the company’s industry growing?Performing due diligence on several companies in the same industry can give an investor significant insight into how the industry is performing and which companies have the leading edge in that industry. Step 4: Valuation Multiples- Many ratios and financial metrics are used to evaluate companies, but three of the most useful are the price-to-earnings (P/E) ratio, the price/earnings to growth (PEGs) ratio, and price-to-sales (P/S) ratio. These ratios are already calculated for you on websites such as Yahoo! Finance.As you research ratios for a company,