Due diligence is a term that is often used in investments, real estate, mergers and acquisitions (M&A) deals, agreements, law, and even everyday life.
But very few people understand what the phrase “do your due diligence” means because it means different things in different situations.
This guide will expose you to everything you need to know about “due diligence,” such as what it means in different contexts, examples, types, and situations where you need to “do due diligence.”
Overview
Due diligence is a reasonably popular phrase. It broadly refers to the process of examining and verifying facts about a company or investment opportunity when used in business. It comes up specifically for compliance teams when considering agreements with new vendors and third parties. However, defining due diligence and how to implement it into your practices might be challenging.
The term ‘due diligence’ has a simple definition in the dictionary. Depending on the context, the term can have various implications, particularly for corporations, NGOs, and educational institutions.
Merriam-Webster defines due diligence in business. According to the definition, due diligence research and analysis of a firm or organization done in preparation for a business transaction (such as a corporate merger or the purchase of securities).’
What Exactly Is Due Diligence?
Due diligence refers to an organization’s measures to thoroughly examine and verify an entity before entering into a business partnership with a vendor, a third party, or a client.
Due diligence, in general, business terms, means carefully and attentively vetting issues that influence the business. Being proactive rather than reactive in reaction to difficulties is what due diligence entails.
Due Diligence in Business
Due diligence in business is widely regarded as excellent practice in all transactional actions. While this entails purchasing entire organizations, it includes other purchases, such as software, hardware, or other products that require company dollars. The goal is to ensure that only good purchases are made that suit the demands and standards of the entire company.
A new piece of commercial software for a firm would be an example. To conduct proper due diligence, a review into the product’s pricing is required, as well as the following:
- Viewing previous customer reviews
- Determining whether the security software is compatible with current systems
- Determining whether more expenditures for the software package are required (for example, subscriptions).
Due Diligence Types
Due diligence can take various shapes depending on its aim.
- Commercial due diligence takes into account a company’s market share and competitive posture, as well as its future prospects and growth opportunities. This will take into account the company’s supply chain from vendors to customers, market analysis, sales pipeline, and research and development pipeline. This might also include a company’s general operations, such as management, human resources, and information technology.
- Legal due diligence ensures that a company’s legal, regulatory, and compliance eggs are all in the same basket. Everything from pending litigation to intellectual property rights to ensuring the company was properly incorporated is covered.
- Financial due diligence is the process of auditing a firm’s financial statements and books to ensure that there are no irregularities and that the company is financially stable.
- Tax due diligence examines a company’s tax exposure, whether it owes back taxes, and where it might lower its tax burden in the future.
What is the definition of Financial Due Diligence?
Financial due diligence is an in-depth evaluation of another company’s financial information. Firms conduct financial research before getting into a deal with another firm.
This finally aids in determining its worth and calculating potential hazards. Common conditions necessitating financial inquiry include starting a large investment, merging or acquiring a company.
Many people wonder what kind of due diligence documentation should be gathered. The following materials and papers were examined during the financial due diligence:
- Trends in revenue, profit, and growth
- Options and stock history
- Debts, both short and long term
- Multiples and ratios of valuation in reference to competitors and industry benchmarks
- Balance sheets, income statements, and cash flow statements
Areas of Due Diligence
Due diligence is often performed in business because of two types of transactions. This involves the sale or purchase of goods and services and the merger or acquisition of another business organization.
Each transaction is normally carried out in a number of places.
In typical transactions, the purpose of investigation is to determine whether the purchase is a sound decision. Items that may be evaluated include:
- Warranties
- Inventories
- Customer feedback on the seller
Due diligence in mergers and acquisitions is far more extensive.
It examines things like:
- Financial statements
- Business strategies and practices
- The consumer base of the target company
- Products or services in the works
- Data on human resources
- Sustainability and the environment
Hard Due Diligence vs. Soft Due Diligence
Due diligence can be classified as “hard” or “soft” depending on the approach taken.
The statistics and data found on financial statements such as the balance sheet and income statement are the focus of hard due diligence. This can include fundamental research and the use of financial ratios to gain an understanding of a company’s financial status and generate future projections. This sort of due diligence can also detect red flags or financial discrepancies; nevertheless, hard due diligence is prone to rosy interpretations by eager sellers.
Soft due diligence works as a check when numbers are distorted or overemphasized.
Soft due diligence is a more qualitative method that considers factors such as management quality, people within the organization, and customer loyalty. Employee relationships, organizational culture, and leadership are all examples of business success drivers that data cannot fully express. When M&A transactions fail, which is estimated to be 70%-90% of the time, it is typically because the human factor is overlooked.
Examples of Due Diligence
Several examples of diligent usage are provided below:
- Conducting rigorous checks on a property prior to purchase to ensure that it is a smart investment
- An underwriter who examines an issuer’s business and operations before selling it.
- Prior to launching a merger, one company thoroughly investigates another to see whether it is a good investment.
- Consumers who read online reviews before purchasing an item or service
- People checking their bank accounts and credit cards to ensure that there is no strange activity.
- An individual who tests or samples a product in a store before purchasing it.
The Three Due Diligence Principles
Due diligence is a crucial method for firms to identify risk in advance. But it could also be a human rights concern. The United Nations adopted its Guiding Principles on Business and Human Rights in 2011. This document outlines three principles organizations can use to ensure that their operations do not jeopardize human rights.
While they are human rights-related, they are also essential components of any efficient due diligence program. They are as follows:
- Identify and Assess: Organizations are responsible for determining if their operations may have a human rights impact and determining the level to which that risk exists.
- Prevent and mitigate: Next, businesses must act in good faith to prevent such risks and/or mitigate any current or future consequences.
- Accountability: Organizations must also keep a detailed record of how they will proactively address any potential human rights problems.
How to Conduct Due Diligence on Stocks
Individual investors conducting due diligence should follow the ten procedures outlined below. Most are connected to stocks, but they can also be used for bonds, real estate, and a variety of other investments.
Step 1: Examine the Company’s Capitalization
The market capitalization, or overall value, of a corporation indicates the volatility of its stock price, the breadth of its ownership, and the potential size of the company’s target markets.
Large-cap and mega-cap corporations typically have solid revenue streams and a wide, diverse investor base, resulting in reduced volatility. Mid-cap and small-cap firms’ stock prices and earnings often fluctuate more than giant corporations’.
Step 2: Revenue, Profit, and Margin Trends
The revenue or net income or profit of the company will be listed on the income statement. That is the end result. Tracking trends in a company’s revenue, operational expenses, profit margins, and return on equity is critical.
The profit margin of a corporation is computed by dividing its net income by its revenue. To obtain perspective, examine profit margins over several quarters or years and compare them to companies in the same industry.
Step 3: Industry and Competitors
Now that you know how big the firm is and how much money it makes, it’s time to assess the industry in which it works and its competitors. Every business is defined in part by its competitors. Due diligence entails comparing a company’s profit margins to those of two or three competitors. Questions to consider include: Is the company a leader in its industry or in its specialized target markets? Is the industry in which the company operates expanding?
Due diligence on numerous companies in the same industry can provide an investor with valuable insight into how the industry is performing and which companies have a competitive advantage.
Step 4: Calculate Valuation Multiples
Many ratios and financial indicators are used to evaluate organizations, but the price-to-earnings (P/E) ratio, the price/earnings to growth (PEGs) ratio, and the price-to-sales (P/S) ratio are three of the most important. On services like Yahoo! Finance, these ratios are already calculated for you.
When researching ratios for a company, compare it to its competitors. You may find yourself becoming more interested in a rival.
- The P/E ratio indicates how much expectation is built into the company’s stock price. It’s a good idea to look at this ratio over several years to ensure that the current quarter isn’t an outlier.
- The price-to-book (P/B) ratio, enterprise multiple, and price-to-sales (or revenue) ratio all evaluate a company’s valuation in proportion to its debt, yearly revenues, and balance sheet. Peer comparison is crucial here because healthy ranges varies by industry.
- The PEG ratio indicates investor expectations for the company’s future profits growth and how they relate to the existing earnings multiple. Under typical market conditions, stocks with PEG ratios close to one are considered fairly valued.
Step 5: Administration and Share Ownership
Is the company still led by its founders, or has the board added many new faces? Younger businesses are typically led by their founders. Examine the biographies of managers to determine their level of competence and experience. The company’s website contains biographical information.
Due diligence considers if founders and executives own a large proportion of the company’s stock and whether they have recently sold stock. High ownership by top management is a good, whereas minimal ownership is a warning sign. Shareholders are best served when people in charge have a vested interest in stock performance.
Step 6: Balance Sheet
The company’s consolidated balance sheet will indicate its assets and liabilities and how much cash is available.
Examine the company’s debt level and how it compares to others in the industry. Debt is not always a bad thing, depending on the business plan and industry of the organization. However, make certain that those debts are highly rated by rating agencies.
Some businesses and industries, such as oil and gas, demand a large amount of money, whilst others require little fixed assets and capital expenditure. Determine the debt-to-equity ratio to determine the company’s positive equity. Generally, the more cash a firm earns, the better an investment it is because the company can meet its debts while still growing.
If the total assets, total liabilities, and stockholders’ equity figures shift significantly from one year to the next, try to figure out why. Reading the financial statement footnotes and management’s explanation in quarterly or annual reports might shed light on what’s really going on in a company. The company could prepare for a new product launch, stockpile retained earnings, or be in financial distress.
Step 7: Review the Stock Price History
Investors should investigate the stock’s short-term and long-term price changes, as well as if the stock has been volatile or stable. Compare profits produced in the past and see how they correlate with price change.
Remember that past performance is no guarantee of future price movements. For example, if you’re a retiree seeking for dividends, you might not want a volatile stock price. Stocks that are constantly volatile tend to have short-term owners, which can create additional risk for some investors.
Step 8: Stock Dilution Options
Investors should understand how many shares the firm has outstanding and how that number compares to the competition. Is the corporation going to issue more stock? If this is the case, the stock price may suffer.
Step 9: Predictions
Investors should learn what Wall Street experts predict for earnings growth, revenue, and profit over the next two to three years. Investors should also look for comments about long-term industry trends, as well as company-specific news about partnerships, joint ventures, intellectual property, and new products or services.
Step 10: Consider both long-term and short-term risks.
Make certain that you understand both industry-wide and company-specific risks. Are there any unresolved legal or regulatory issues? Is there inconsistency in management?
Investors should always play devil’s advocate, imagining worst-case situations and their potential effects on the stock. How would it affect the company if a new product fails or a competitor introduces a new and superior product? How would a rise in interest rates affect the business?
After you’ve performed the preceding steps, you’ll have a greater understanding of the company’s performance and how it compares to the competitors. You will be better prepared to make an informed decision.
Related Articles
- Due Diligence: Meaning, Examples, & 9 Most Common Types
- BUYING A BUSINESS LOAN: Steps to Buying an Existing Business
- Due Diligence Process: What is Due Diligence? (10 Effective Steps)
- How To Buy Land: Step-by-step Guide
- What Happens During and After The Due Diligence Period
References
