A question I often get is “How do you go about doing your due diligence? What do you look out for when analysing a company?”. With that in mind, this week’s edition is going to examine how you can do your own due diligence.
One of the most important aspects of investing is building your own conviction in a company and this comes from doing your own due diligence. Anyone can copy the buys of a random stranger on the internet. However, this is an extremely dangerous thing to do and is not encouraged. Your time horizon and goals might be at polar opposites. Furthermore, during times of uncertainty or during a bear market, if you have invested blindly you will not understand why you have invested in the first place and doubts will begin to creep into your head.
When performing due diligence we are aiming to get a fuller picture about the company we are researching as a potential investment opportunity. I find having a checklist useful as it ensures that I do not forget any areas that I have determined as important. Below is what my due diligence checklist looks like.
One of the first things that we need to do is form a mental image of the company you're researching. By looking at the company's market capitalisation we can see just how big the company is.
The market capitalisation is a good indicator of how volatile the stock is likely to be, how diverse the ownership might be, and the potential size of the company's markets. For example, large-cap companies tend to have more stable revenue streams and less volatility. Mid-cap and small-cap companies, meanwhile, may only serve niche areas of the market and may have more fluctuations in their stock price and earnings.
Another vital fact to check is what stock exchange that shares are traded on. Are they based in the United States or on a European exchange? This will also indicate if you will have any foreign currency exposure from investing in the stock.
Recommended Tools & Resources: Yahoo Finance
2. Revenue & Margins
When beginning to look at the financial numbers related to the company you're researching, a good place to start is with the revenue, profit, and margin trends. Look at the revenue and net income trends for the past couple of years by taking the information directly from the income statement as part of the financial statements or on a news site such as Yahoo Finance that allows you to easily search for detailed company information using the company name or ticker symbol.
These types of sites provide historical charts showing a company's price fluctuations over time, in addition to giving the price-to-sales (P/S) ratio and the price-to-earnings (P/E) ratio. When looking at these recent trends in both, note whether growth is choppy or consistent, or if there are any major swings in either direction.
You should also review profit margins to see if they are generally rising, falling, or remaining the same. You can find and calculate specific information regarding profit margins by using the financial statements. For further details on the Income Statement refer to How to Interpret Financial Statements.
Recommended Tools & Resources: Yahoo Finance, Entity Financial Statements
4. Valuation Multiples
Next you'll want to review the price/earnings (P/E) ratio for both the company you're researching and its competitors. Make a note of any large differences in valuations between the company and its competitors.
P/E ratios can form the initial basis for looking at valuations. While earnings can and will have some volatility, valuations based on trailing earnings or current estimates are a yardstick that allows instant comparison to broad market multiples or direct competitors.
At this point, you'll begin to get an idea as to whether the company is a growth stock or a value stock. Along with this, you should have a general sense of how profitable the company is. It's generally a good idea to examine a few years' worth of earnings figures to make sure the most recent earnings figures used to calculate the P/E ratio is consistent and not being thrown off by a large one-time adjustment or charge.
Not to be used in isolation, 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, revenues, and the balance sheet. As ranges in these values differ from industry to industry, reviewing the same figures for some competitors or peers is a key step. Finally, the price/earnings to growth (PEG) ratio brings into account the expectations for future earnings growth and how it compares to the current earnings multiple. For further details on valuation multiples refer to Valuation Multiples.
Recommended Tools & Resources: Yahoo Finance, Entity Financial Statements
4. Balance Sheet and Cashflow Strength
Reviewing your company's balance sheet enables a view of the overall level of assets and liabilities, cash levels and the amount of long-term debt held by the company. A lot of debt is not necessarily a bad thing and depends more on the company's business model than anything else.
Some companies and industries are very capital intensive, while 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.
If the total assets, total liabilities, and stockholders' equity change materially from one year to the next, try to understand why. Reading the footnotes that accompany the financial statements and the management's discussion in the quarterly or annual report can shed some light on the situation. The company could be preparing for a new product launch, accumulating retained earnings, or simply blowing away precious capital resources. What you see should start to have some deeper perspective after having reviewed the recent profit trends.
As the saying goes “Cash is King” therefore the Cashflow Statement is a very important financial statement to analyse. While cash flow refers to the cash that is flowing in and out of a company, profit refers to what remains after all of a company’s expenses have been deducted from its revenues and are not necessarily cash based. Both are important numbers to know, however while management may be able to manipulate when revenue is recognised and when expenses are accrued, it is very difficult to fudge cash flow. I pay special attention to free cash flow and cash flow from operations. For further details on the Balance Sheet and Cashflow Statement refer to How to Interpret Financial Statements.
Recommended Tools & Resources: Financial Statements
5. Stock Price History
Next we need to establish how long the shares have been trading, as well as both short-term and long-term price movement. Has the stock price been choppy and volatile, or smooth and steady? Stocks that are continuously volatile tend to have short-term shareholders, which can add extra risk factors to certain investors.
Recommended Tools & Resources: Yahoo Finance, Trading View
6. Industries and Competitors
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. Compare the margins of two or three competitors. Every company is partially defined by who it competes with. Just by looking at the major competitors in each line of the company's business (if there is more than one), you may be able to determine how big the end markets are for its products.
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. If you're still uncertain about how the company's business model works, you should look to fill in any gaps in your knowledge before moving forward. If you can’t explain how the company or how it makes money to a ten year old then you probably don’t understand the company well enough. Sometimes just reading about competitors may help you understand what your target company actually does.
Recommended Tools & Resources: Yahoo Finance, Google Search
7. Management and Ownership
As part of performing due diligence on a stock, 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, as 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.
Also 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 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.
Recommended Tools & Resources: Company website, Openinsider.com
Setting this vital piece aside for the end makes sure that we're always emphasizing the risks inherent with investing. Make sure to understand both industry-wide risks and company-specific ones. Are there outstanding regulatory issues? 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/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.
This is essentially the opposite of risks. What are the opportunities within the industry and also specific to the company? Is the total addressable market increasing or shrinking? Are there any new products or services in the pipeline? Are there any secular growth trends that will benefit the company? Any recent acquisitions? Here we are often thinking of the best case scenarios.
Having an inquisitive nature is an important trait for any investor. An internet search can go a long way in this day and age. Can you find any other information that might be relevant to your company? What you consider important or relevant to a software company will vary widely from what you might consider important to a healthcare company. I like to have a quick scan of Twitter before I invest just to check that there has not been any breaking news that I might have missed that would impact my investment thesis. Having first hand experience of the product or service is an underrated part of the due diligence process. If you like it chances are other people will too and vice versa. If you have not used the product or service, customer review sites and product tutorials on YouTube can offer a good substitute.
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Wolf of Harcourt Street
Disclaimer: I am not a financial adviser and I am not here to give specific financial advice. The opinions expressed are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. The information is based on personal opinion and experience, it should not be considered professional financial investment advice. There is no substitute for doing your own due diligence and building your own conviction when it comes to investing.