Financial due diligence: the essentials in 9 steps

Due diligence is the process of a thorough and comprehensive investigation of a business.

It can be carried out for various reasons: investors will do it as part of their fundamental analysis of a stock; venture capitalists may carry it out before they invest in a business.

Whatever the reason, due diligence fulfils the purpose of confirming the material facts by carrying out an examination of a company in order to gain an in-depth understanding or, in the case of an investor, an integral part of calculating the intrinsic value of the stock.

Carrying out due diligence is like doing your homework as an ‘A’ student – you pay attention to details and put in the extra effort.

Here are nine essentials to cover if you want to build a thorough financial picture – no matter what the investment:

1. A true believer       

First, before you go down the rabbit hole of due diligence, make sure it’s a company you truly believe in and think is well worth the effort of deep, sometimes tedious, research and time. 

They are literally tens of thousands of companies to choose from and you don’t want to investigate them all. A central tenet for many investors is only to invest in companies they understand.

Don’t be afraid to simply monitor a company for a period of time before you commit to gathering the necessary financial and industry information.

Give yourself a fighting chance before you delve deeper by determining whether an investment fits in with the aims of your investment portfolio and with your risk profile.

A willingness to carry out due diligence will separate a serious investor from a neophyte who only acts on impulse. The serious investor will not only want to understand what she/he is investing in but also how to make money from the investment.

2. Cover your bases: market capitalisation

Understanding the size of the company you are investigating is a critical first step, because it can reveal many characteristics.

Market capitalisation is determined by calculating the number of outstanding shares by the current market price of a share. The size of market capitalisation generally equates with the volatility of the stock and can give you an indication of:

• How the market is valuing the company
• The breadth of its ownership
• The size of the company’s end markets
• Its growth prospects
• Whether it may be a potential target for mergers and acquisitions

Generally, the larger the capital size the greater the stability of its share price and likelihood of it paying dividends.  Smaller caps will have more fluctuations in their stock price and earnings.

Where companies are listed is also important. Large-cap companies in the UK are generally listed on the FTSE100 index, which accounts for the top 70% of the capitalisation of the domestic stock market.

These are the largest companies in the world, some with recognisable brands. They will have global operations and revenue streams.

For example, private equity group 3i, British American Tobacco and Sky are among the largest companies listed on the FTSE100 as of April 2017.

The FTSE 250 will list mid-cap companies that range between £4bn and £500m, such as Bovis Homes and JD Sports. The FTSE Small Cap lists stocks worth under £150m.

Large-cap companies in the UK are generally listed on the FTSE100 index

3. The deep dive: gross revenue, profit and margin trends

Due diligence is about gathering hard factual information, and key to this is the numbers.

The assessment of the financial strength of the company can only be undertaken by reviewing the financial statements found in the annual and quarterly reports.

Figures for revenue and profitability margins are probably the best place to begin and it’s a good idea to gather figures for a minimum three-year period. Profitability margins, such as gross profit margin, are useful for determining how much profit a company is taking from its revenue.

Profit margin or gross profit is the money remaining once total costs are deducted from the gross revenue. Companies with consistent increases in gross profit margin shows they are likely to have good control over their costs.

Gross and net profit margins when compared with prior periods and with industry statistics can reveal much about a company’s operating efficiency and its competitive abilities.

Comparing figures for current and previous periods reveals trends; further comparison to other similar businesses or an industry composite will tell you how well a company is doing against its competitors.

Other significant figures to review are price-to-sales (P/S) ratio and price-to-earnings (P/E) ratio, which signal how much the market expects a company to grow. They vary from sector to sector and are useful in comparing similar stocks.

The P/E ratio (also called a multiple) is an essential metric for every investor to consider because it gives investors an idea of how the market is valuing a company’s stock.

The P/E ratio measures a company’s current share price against the reality of what it earns in per-share income.

The P/S ratio in a similar way divides the market cap by current revenue.

The P/E and P/S ratio are quoted ‘trailing twelve months’ (TTM). This is the view from the four previous quarters, as well as a forward consensus view of what analysts estimate earnings expectations to be, applied to the current share price.

The higher the P/E and P/S ratio, the more an investor is paying and the greater the expected earnings growth. High P/E stocks tend to be young, fast-growing companies and are far riskier than those with a low P/E.

Low P/E stocks will tend to be in the more mature industries with expected lower growth or the more established companies with long records of earnings stability and dividend paying.

4. Couching it in competition and industry

Industry overviews are important because you are able to couch whether there is any disconnect between the market valuation and the broader growth.

Where does your company sit within the industry in terms of earnings and growth expectations? What is your selected company’s business model?

What about industry trends and competitors? Who are they? Having answers to these questions should create a view of the industry and help you to be aware of developments.

It’s ideal to compare the margins of a couple of competitors too. Gathering information about specific sectors can be gathered first from wherever your account is housed. Utilise their online research tools and, certainly, company news from mainstream publications such as daily newspapers and online news agencies like Reuters.

There are online stock market investment research websites that offer free information, such as Motley Fool, the Street, Zacks Investment Research, and the Wall Street Journal and its other publications such as Barron’s and SmartMoney.

You can also pony up for a more expensive option of subscriptions from companies such as Dun & Bradstreet that provide comprehensive market and industry insights. If you go this route, make sure it’s a legitimate service.

5. Valuation and balance sheet exam

When it comes to valuation, it’s all about the earnings and is thus an important metric, particularly when it comes to fundamental analysis users seeking to find intrinsic value.

At this point you get to the finer details of your due diligence investigation and the picture of the value of a company becomes much clearer.  

We know the P/E ratio tells you what the potential of a company is like but used in conjunction with other metrics – price-to-book (P/B) ratio, price-to-sales (revenue) and the Enterprise Value/EBITDA multiples – allow for a more rounded and deeper view than just market capitalisation.

These figures help you get a more accurate view of the company as you take into account its debt, annual revenues and balance sheet.

Remember, part of the process is to do a valuation not only of the potential company but also a few of its peers.

The balance sheet is a snapshot of the company’s financial position at a specific period of time and shows assets, liabilities and owner’s equity on a given date.

Balance sheet examination involves paying attention to items such as assets and liabilities and cash levels to see whether there is enough to meet short-term liabilities.

Depending on the business model, you can see the level of debt for the company and determine if it’s appropriate when compared with industry peers.

Proper analysis means looking at prior balance sheets and other operating statements, including income and cash-flow statements, along with ratios such as debt to equity.

Debt to equity ratio can show the extent to which equity can cover creditors’ claims, again compared with sector peers to see what is standard. 

Don’t forget to read the footnotes, which can explain changes and adjustments to items such as shareholders’ equities or pension liabilities.

Balance sheet examination involves paying attention to items such as assets and liabilities and cash levels to see whether there is enough to meet short-term liabilities.

6. Quality of management and ownership

It’s not all about numbers. Less tangible is company management and ownership, but there are still suitable metrics to help you evaluate these qualitative aspects of a company.  

Glean information from the company’s website and/or from Companies House online services, for which you will have to pay a small fee to register.

Vital questions should be:

• Who is running the company?
• Is it a relatively young company still run by its founders?  
• What about the experience of managers?
• How long has the CEO and top management been in charge?
• What is the CEO’s compensation package?

The number of shares held by the founders and managers is also significant. High personal ownership is considered a positive, as is insiders buying shares in their company because they believe in the company’s performance.

Pay attention to how long they are holding their shares to make sure they aren’t flipping for a quick profit.

7. Short stop to stocks – history and options

Now consider the historical volatility of the stock and what the average shareholder may have experienced while holding the stock. Many analysts and investors look back three to five years.

This gives you some idea of the risk in terms of price movements. A stock with a price that fluctuates wildly and/or erratically is considered highly volatile. A stock that maintains a stable price has low volatility.   

Figure out the number of authorised and outstanding shares as well as the number of stock options and warrants that may cause dilution. This can have an impact on the level of ownership. Some analysts offer the conversion expectations of stock options based on different stock price scenarios.  

8. On the horizon

What caught your eye initially about the stock can now be examined fully based on the data you have gathered.

So is the innovation or new product likely to be successful based on the metrics you have gathered?

A good place to look for pointers is in the management discussion and analysis (MD&A) of a company’s annual report. Although inclined to give a rosy outlook, it can highlight areas to investigate further.

For example, it may briefly discuss long-term industry trends and potential future risks, but these are factors you’ll want to understand well.

Also, the consensus of analysts about potential revenue and profit estimates out to a three-year horizon can provide an idea about market expectations.

You should have a handle on other possibilities tied to the sector, including any joint ventures or legal issues that a company will have to contend with.

9. The secret – always ongoing and seen through risk

Review your company but do so always through the prism of risk, which is inherent to investing.

However, it pays to understand the sector and company risk and always to take a look at a company’s governance structure, which can ensure risks are being well managed.

If you are new to investing you may think of due diligence as a one-off process done prior to making that investment decision.

However, professional investors using the fundamental analysis investment style see due diligence as a routine, rigorous part of maintaining their portfolio.

For them due diligence is an ongoing process for projecting future results.

After all, they have already laid much of the groundwork. Like excellent students, they have a comprehensive understanding of the company and businesses they now own a part of as shareholders. 

Equally as important, if the conclusion of a due diligence investigation finds that a company doesn’t meet your needs or portfolio requirements, abandon it and find another company.