Due Diligence in 10 Easy Steps

Due diligence is defined as an investigation of a potential investment (such as a stock) or product to confirm all facts. These facts can include such items as reviewing all financial records, past company performance, plus anything else deemed material. For individual investors, doing due diligence on a potential stock investment is voluntary, but recommended.

This article will discuss ten steps you should take on your first review of a new stock. Performing this due diligence will allow you to gain essential information and vet out a possible new investment.

The steps are organized so that with each new piece of information, you'll build upon what you previously learned. In the end, by following these steps, you'll gain a balanced view of the pros and cons of your investment idea. This will allow you to make a rational investment decision.

Step 1: Company Capitalization

The first step is for you to form a mental picture or diagram of the company you're researching. This is why you'll want to look at the company's market capitalization, which shows you just how big the company is by calculating the total dollar market value of its outstanding shares.

The 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 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. 

At this step in performing your stock due diligence, you're not making any judgments pro or con regarding the stock. You should focus your efforts on accumulating information that will set the stage for everything to come. When you start to examine revenue and profit figures, the information you've gathered about the company's market capitalization will give you some perspective.

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, such as whether you can own the shares in your current investment accounts.

Step 2: Revenue, Margin Trends

When you begin looking at the financial numbers related to the company you're researching, it may be best to start with the revenue, profit, and margin trends. Look up the revenue and net income trends for the past two years at a financial news site that allows you to easily search for detailed company information using the company name or ticker symbol.

These sites provide historical charts showing a company's price fluctuations over time, plus they'll give you the price-to-sales (P/S) ratio and the price-to-earnings (P/E) ratio. Look at the recent trends in both sets of figures, noting whether growth is choppy or consistent, or if there are any major swings (such as more than 50% in one year) in either direction.

You should also review profit margins to see if they are generally rising, falling, or remaining the same. You can find specific information regarding profit margins by going directly to the company's website and searching their investor relations section for their quarterly and annual financial statements. 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 with whom it competes. Compare the margins of two or three competitors. Every company is partially defined by its competitors. 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 here before moving forward. Sometimes just reading about competitors may help you understand what your target company actually does.

Step 4: Valuation Multiples

Now it's time to get to the nitty-gritty of performing due diligence on a stock. You'll want to review the price/earnings to growth (PEG) ratio for both the company you're researching and its competitors. Make a note of any large discrepancies in valuations between the company and its competitors. It's not uncommon to become more interested in a competitor stock during this step, which is perfectly fine. However, follow through with the original due diligence while noting the other company for further review down the road.

P/E ratios can form the initial basis for looking at valuations. While earnings can and will have some volatility (even at the most stable companies), 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 probably begin to get an idea if the company is a "growth stock" versus "value stock." Along with these distinctions, 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 net earnings figures to make sure the most recent earnings figure (and the one used to calculate the P/E) is normalized, 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, annual revenues, and the balance sheet. Because ranges in these values differ from industry to industry, reviewing the same figures for some competitors or peers is a key step. Finally, the PEG ratio brings into account the expectations for future earnings growth and how it compares to the current earnings multiple.

Step 5: 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.

Step 6: Balance Sheet Exam

Many articles could easily be devoted to how to do a balance sheet review, but for our initial due diligence purposes, a cursory exam will do. Review your company's consolidated balance sheet to see the overall level of assets and liabilities, paying special attention to cash levels (the ability to pay short-term liabilities) 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 as a whole) 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 "top line" balance sheet figures of total assets, total liabilities, and stockholders' equity change substantially from one year to the next, try to determine why. Reading the footnotes that accompany the financial statements and the management's discussion in the quarterly/annual report can shed some light on the situation. The company could be preparing for a new product launch, accumulating retained earnings, or simply whittling away at precious capital resources. What you see should start to have some deeper perspective after having reviewed the recent profit trends.

Step 7: Stock Price History

At this point, you'll want to nail down just how long all classes of 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? This outlines what kind of profit experience the average owner of the stock has seen, which can influence future stock movement. Stocks that are continuously volatile tend to have short-term shareholders, which can add extra risk factors to certain investors.

Step 8: Stock Options and Dilution

Next, you'll need to dig into the 10-Q and 10-K reports. Quarterly SEC filings are required to show all outstanding stock options as well as the conversion expectations given a range of future stock prices.

Use this to help understand how the share count could change under different price scenarios. While stock options are potentially a powerful motivator for retaining employees, watch out for shady practices like re-issuing of "underwater" options or any formal investigations that have been made into illegal practices like options backdating.

Step 9: Expectations

This due diligence step is a sort of "catch-all," and requires some extra digging. You'll want to find out what the consensus revenue and profit estimates are for the next two to three years, long-term trends affecting the industry, and company-specific details about partnerships, joint ventures, intellectual property, and new products and services. News about a product or service on the horizon may be what initially interested you in the stock. Now is the time to examine it more fully with the help of everything you've accumulated thus far.

Step 10: Risks

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 legal or regulatory matters? 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.

The Bottom Line

Once you've completed these steps you should be able to evaluate the company's future profit potential and how the stock might fit into your portfolio or investment strategy. Inevitably, you'll have specifics that you will want to research further. However, following these guidelines should save you from missing something that could be vital to your decision.

Veteran investors will throw many more investment ideas (and cocktail napkins) into the trash bin than they will keep for further review, so never be afraid to start over with a fresh idea and a new company. There are literally tens of thousands of companies out there to choose from.