“DD” stands for due diligence, which is a form of investigation recommended for individual investors looking to invest in the stock market. While you’re not required to perform DD, this research could reveal valuable information about your potential investment. Due diligence may include reviewing a company’s financial performance, considering professional opinions, and examining the stock’s performance history.
Due diligence is used in a lot of aspects of business and finance. Essentially, it involves doing in-depth research before making a big decision, such as buying a house. The principle also applies to the stock market, where investors should conduct due diligence before buying any investment.
In this article, we’ll discuss how to perform due diligence on your stocks, why it’s important to, and the risks you could open yourself up to if you don’t.
What is due diligence in stocks?
Due diligence in stocks is similar to DD in other instances, though the information you’re looking for varies. For investors, due diligence generally includes researching and fact-checking investment-related information before committing money to an investment opportunity.
Depending on the context and your investment strategy, you may:
- Review a company’s fundamentals
- Examine revenue, cash flow, liabilities, and total assets
- Dig through the company’s balance sheet
- Compare competitors based on multiples and market capitalization
- Look at the stock price history
As an individual investor, you’re not technically required to perform due diligence. However, spending some time analyzing a stock before buying can help you sidestep potential financial landmines.
Due diligence: then and now
Due diligence, and later the acronym DD, appeared in the United States after the Securities Act of 1933 passed. The law required securities dealers and brokers to fully disclose all “material evidence” (benefits and risks) when selling securities.
However, the law’s writers also wanted to prevent brokers and dealers from being penalized for failing to disclose information they couldn’t have known. Thus, “due diligence” was born as a legal defense. As long as brokerages complete a reasonable investigation and fully disclose results, they can’t be held liable for undiscovered information.
Due diligence in the modern age
Nowadays, DD often crops up in the investment markets. While broker-dealers and financial advisors legally must perform due diligence before acting, it’s merely recommended for individual investors. Other entities that may do research before acting include analysts, fund managers, and companies considering mergers or product releases.
Due diligence as a legal concept
Due diligence also holds weight in legal contexts. Essentially, when one person or entity acts on another’s behalf, they must perform due diligence before acting. Doing so prevents those with authority from taking advantage of others — failing to do so can lead to legal action.
Performing due diligence with stocks
Before purchasing any investment, including stocks, you should conduct a thorough review to learn as much as possible before you invest.
This multi-step process generally looks at a company’s profit margins, fundamentals, and stock price history. You may also examine revenue earned by competitors, legal involvement in the company or industry, and the management structure.
However, your due diligence can go beyond that. After learning about an investment, you can determine how it fits in your portfolio and whether that particular stock is the right choice for your investment style.
To get another opinion on how your potential investment could fit in, talk with a brokerage. They can give you a better idea of how your assets may work together in the current market to produce better overall returns.
Due diligence checklist
To help you on your investing journey, we’ve put together a handy “due diligence checklist” to make sure you tick all the boxes, every time. Remember, in the world of fact-checking, you can’t turn over too many stones.
1. Read what the professionals have to say
Once you find a stock you’re interested in, an excellent starting place is professionals’ analyses. Seeing how the pros view your prospective investment can indicate early on whether it’s worth more research and reveal outsiders’ insights. Plus, their reports might point you in the right direction for further research or to an entirely different asset.
2. Know their finances
To gain an idea of a company’s fundamentals, you should turn to its balance sheet next. Here, you’ll be able to:
- Examine a company’s revenues and cash flow
- Look at profit margins
- See an accounting of assets and total liabilities
- Determine whether it has stable revenue streams
Bear in mind that profit debt structures vary between companies and industries. Be sure to determine a normal “baseline” for the industry before making a judgment.
3. Identify short- and long-term trends
DD in stocks also means examining the company’s financial statements for various trends. Look back through the years to see how profit margins, stable revenue streams, and total liabilities change over time.
This step will reveal the financial management of the company. Companies that regularly increase profits while managing long-term debts often have great growth potential. By contrast, companies that bleed revenue and rack up debt may make poor investments.
4. Get the scoop on management
You can tell a lot about a company by its management structure and activities. For example, high turnover in the upper echelons can indicate trouble in paradise. (Though older companies may see more turnover when the original founders leave.)
Furthermore, investigate how company owners and insiders handle stock transactions. Companies on the up-and-up generally see higher-ups regularly investing or retaining their positions. But if the owners or board of directors all dump their stock at once, something is going on behind the scenes.
5. Look at the competition
Before investing in a company, look at what else is available in the stock market. Examining the balance sheet and activities of direct competitors reveals how an investment’s financial performance stacks up.
Don’t be afraid to ask hard questions like:
- Is the company an industry leader?
- Does the company have a competitive advantage?
- Do its products target a unique niche?
- Is the industry growing, stable, or shrinking?
- How do the company’s assets and market share stack up?
Gathering these answers should reveal if, how, and where a company beats its competitors.
6. Check out their multiples
The next step is to review a firm’s financial performance through its valuations, such as price-to-earnings (P/E), price-to-earnings-growth (PEG), and price-to-sales (P/S) ratios. These numbers reveal specific insights about a company:
- P/E ratio. These values tell you how a company’s stock price relates to its earnings.
- PEG ratio. This is an adjustment to the P/E using the expected earnings growth rate. Using this number, you can compare two companies that have similar P/E ratios.
- P/S ratio. This ratio is a valuation metric comparing the stock price to its revenue.
Furthermore, you can use these ratios to directly compare companies of similar size within an industry.
7. Examine their market capitalization
A company’s market cap (market capitalization) represents its value if it repurchased all its shares at the current market price. Market cap can reflect a stock’s stability, size, and growth in addition to guiding investor expectations.
- Small-cap companies (worth under $2 billion) are the most volatile but have the most long-term growth potential.
- Mid-cap companies (worth $2 billion to $10 billion) have more growth opportunities and middling volatility.
- Large-cap companies (worth over $10 billion) grow the slowest but are less likely to see volatility or bankruptcy.
For the most part, the higher a stock’s market cap, the more stable its revenue and wider its reach. That said, you may need mid-cap and small-cap companies to see the growth you desire.
8. Go through their stock price history
Going through a company’s stock price history is another essential step in the due diligence process. Examining prices over recent quarters (if not years) can reveal short- and long-term trends you may not have noticed previously. You can also compare stock performance against competitors and major economic events to see how it performs under specific conditions.
9. Beware of potential dilution
Another piece of the stock price history puzzle is how many shares are in circulation and how often new shares are released. Every time the company issues new shares, the increased volume can decrease your vote and share price.
10. Consider future expectations
The last step in our due diligence checklist is to gain an idea of what the “Wall Street” (expert analyst) consensus revenue and profit estimates are for future growth. Details about partnerships, intellectual property licenses, new product or service innovations, and more can all influence a company’s expected future returns.
Another great place to look for future expectations of a company is the “Management Discussion & Analysis” section of their quarterly or annual filings (Form 10k or Form 10Q, respectively). This is where the company discloses any risks, future plans, and projects.
Questions to ask when doing due diligence
The due diligence checklist tells you what to look for before you invest. Throughout the process, you should also ask yourself questions about the stock’s performance and your personal goals to determine whether it makes a good fit.
What’s your investment strategy?
One of the biggest questions is how an investment fits into your strategy.
For instance, if you’re a long-term investor who prefers dollar-cost averaging, you may prefer a healthy mix of value and growth stocks. This allows your portfolio to grow while minimizing long-term risks.
By contrast, traders generally care about short-term news, performance, and volatility. Unfortunately, trading is both time-consuming and puts you at risk of falling prey to bear traps, dead cat bounces, and other market whims.
What are the risks?
Throughout your research, you should uncover most of the factors that make up an investment’s risk. Looking through company balance sheets, legal history, and competitive challenges will reveal company- and niche-specific concerns. If a company carries too much risk for your liking, it may not make a good fit.
Can you afford to ride the waves?
The goal of investing is to make money, which requires your portfolio to have enough upside to support you through turbulent times. Unfortunately, that requires you to stomach at least some volatility. More than that, you’ll have to accept that some stocks will produce short- or long-term losses despite your due diligence.
As such, you should only invest the money you can afford to lose at your risk level. Moreover, you should never invest capital you need immediately, as even stable stocks can tank suddenly.
Where is the company in its growth cycle?
Companies tend to follow a general pattern as they grow from small-cap to large-cap status. These patterns often translate directly to stock prices. Growing companies tend to see stock prices climb higher and faster, while large, lumbering companies tend to see more stabilities.
You can examine a company’s place in its growth cycle by examining its expansion potential. Companies that are branching out, hiring new employers, or releasing new products are still growing. But companies that continue on the same path and have bloated balance sheets and large cash flows may be stable in their niche.
How is the overall market doing?
The stock market and economy often travel in cycles together.
- Downturns. During recessions, consumers tighten their belts, which means large, well-established, and essential companies (like utilities and grocers) tend to perform best.
- Upswings. On the other hand, periods of economic growth leads to consumers spend more money. This means smaller or discretionary companies have a chance to shine and outperform the competition.
Knowing where we are in an economic or stock market cycle can help you invest in the stocks most likely to see both short- and long-term growth.
Could your money do better elsewhere?
Lastly, determine if this stock has enough upside potential, or if other stocks could grow your invested capital faster. The goal of investing is to make money, so don’t let it sit in low-growth opportunities if you believe it could make more in a different asset.
If you need some help deciding where to put your money, consider speaking with an investment advisor about your financial goals.
- Due diligence (DD) in the stock market involves investigating a potential investment before committing capital to the investment.
- You may check and double-check financial statements, management structures, legal entanglements, and professional analysts’ recommendations to get a better idea of the stock’s performance.
- You should also compare other stocks in the niche or industry to determine how your pick’s performance holds up.
- After learning the basic information about your potential investment, consider whether the asset will work best in your current portfolio.
View Article Sources
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- What is Averaging Up And Down In The Stock Market? — SuperMoney
- What is a Dead Cat Bounce in Stock Investing? — SuperMoney
- Bear Trap: Stock Market Investing for Beginners — SuperMoney
- Best Brokerages | July 2022 — SuperMoney