Due Diligence Process: What is Due Diligence? (10 Effective Steps)

Due Diligence Process
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Due diligence is the foundation of all successful mergers and acquisitions (M&A). There is absolutely no substitute for thoroughly researching a company and its activities before purchasing it. This guide unveils tons of useful tips and steps that should serve as a starting point for anyone conducting due diligence for the first time. However, this isn’t without a definition of due diligence process as it related to M&A.

Due Diligence Process Definition

Due Diligence Process
Image Credit: M&A Critique Due Diligence Process Definition

Due diligence is a thorough examination or audit of a business that is normally performed prior to a merger or acquisition (M&A). The aim of due diligence in business is to ensure that any decision made about the company in question is informed, increasing your chances of adding value in an M&A transaction.

Moving on, if you are looking for a more elaborate definition, our article on the fundamentals of due diligence will be of great help.

What Is the Importance of Due Diligence?

A merger or acquisition is the most significant corporate activity that any company will pursue.

Due diligence allows businesses to enter into these transactions with confidence.

It also brings considerable value to the buyer by highlighting the target company’s vulnerabilities (or red flags) as well as finding opportunities within the target company that it was previously unaware of.

What are the Difficulties of Due Diligence?

Gaining an in-depth understanding of an organization can be a highly technical method that is beyond the capabilities of most people without prior experience in the industry.

There are several difficulties, but the following are generally among the most frequently encountered:

#1. Not knowing what questions to ask

It is important to know what the problems are and what questions must be answered in order to better examine them.

#2. Slow execution

Asking sellers to obtain paperwork or information will take time, sometimes delaying the transaction’s closing.

#3. Lack of communication

Sellers often treat due diligence as a bother, which leads to impatience, bad communication, and even friction.

#4. Lack of expertise

There is a fair possibility that you would need to recruit someone to help with at least certain aspects of the due diligence process (e.g., an IP expert).

#5. Cost issues

Due diligence can be costly, lasting months and requiring lengthy specialist hours, leading many to mistakenly believe that they can cut corners.

How to Do Due Diligence (Process)

Due diligence is a detailed examination of a commercial enterprise, usually performed by a prospective buyer prior to entering into a business agreement.

Examples include preparing for mergers and acquisitions (M&A) for purchasing new facilities.

However, to complete the investigation, specialized teams collaborate to compile and review data, which includes:

  • Profit and loss statements
  • Accounts payable and receivable
  • Contracts of partnership
  • Contracts already in place
  • Profit and loss statements
  • Results on an annual basis
  • Tax returns
  • Practices of company and operations

Steps in the Due Diligence Process, Policies, and Procedures for a Company or Stock

The following are steps you should follow when delving in to due diligence. This basically covers, process, policies and procedures of due diligence.

#1. Establish the Company’s Capitalization

The first step is to visualize or draw a mental image of the business you’re investigating. This is why you should look at the company’s market capitalization, which calculates the total dollar market value of its outstanding stock to determine how large the company is.

The market capitalization reveals a lot about how volatile the stock will be. It also reveals a couple of other vitals likehow diverse the ownership will be, and the future scale of the company’s end markets. Large-cap and mega-cap firms, for example, have more stable revenue sources and fewer uncertainty. Mid-cap and small-cap firms, on the other hand, can only represent a single segment of the market and can experience greater volatility in stock price and earnings.

At this point in your stock due diligence, you are not making any pro or con decisions about the stock. You should concentrate your energies on gathering knowledge that will lay the groundwork for all that follows. When you start looking at sales and profit statistics, the details you’ve learned about the company’s market capitalization will help put things into perspective.

When looking at the financial numbers for the business you’re investigating, it’s a good idea to start with the sales, benefit, and margin patterns. Look up the sales and net income trends over the previous two years on a financial news website that allows you to quickly search for detailed business details using the company name or ticker symbol.

These websites include historical charts that display a company’s price variations over time, as well as the price-to-sales (P/S) and price-to-earnings (P/E) ratios. Examine the most recent patterns in both sets of data, noting whether growth is choppy or stable, and whether there are any significant fluctuations (such as more than 50% in one year) in either direction.

You should also look at profit margins to see if they are rising, dropping, or staying the same. Furthermore, you will find extensive information about profit margins by going to the company’s website and looking for their quarterly and annual financial statements under the investor relations section. The following step will cover a more extensive usage of this.

#3. Markets and Competitors

Now that you know how big the company is and how much money it makes, it’s time to look at the industries it operates in and who it competes with. Examine the profit margins of two or three competitors. Oftentimes, company do not clearly define their competitors. You may be able to determine the size of the end markets for the company’s products simply by looking at the major competitors in each line of business (if there are more than one).

Many big stock analysis websites provide details about the company’s rivals. Typically, you’ll find the ticker symbols of your company’s rivals, as well as clear comparisons of specific metrics for both the company you’re investigating and its competitors. If you’re still unsure about how the company’s business model operates, you can fill in any holes here before proceeding. Reading about rivals will also help you understand what your target company does.

#4. Calculate Valuation Multiples

Now it’s time to get down to the business of doing due diligence on a stock. You should look at the price/earnings to growth (PEG) ratio for both the business you’re looking at and its rivals. Make a note of any significant valuation disparities between the company and its rivals. It’s normal to become more interested in a competitor stock at this point. See it as a good feeling. However, continue with the original due diligence while mentioning the other business for future analysis.

End-Point

P/E ratios can be used as a starting point for evaluating valuations. Although earnings can and will fluctuate (even at the most stable companies), valuations on the basis of trailing earnings or current expectations provide a quick comparison to broad market multiples or direct competitors.

At this point, you should have a good idea of whether the business is a “growth stock” or a “value stock.” Along with these distinctions, you should have a general sense of the company’s profitability. It’s a good idea to look at a few years’ worth of net earnings figures to ensure that the most recent earnings figure (and the one used to calculate the P/E) is normalized and not skewed by a large one-time adjustment or charge.

The P/E ratio should be seen alongside the price-to-book (P/B) ratio, the business multiple, and the price-to-sales (or revenue) ratio. These multiples illustrate the company’s value in relation to its debt, annual sales, and balance sheet. However, since the ranges of these values vary by industry, it is critical to check the same figures for certain rivals or peers. Finally, the PEG ratio considers potential earnings growth projections and how they relate to the actual earnings multiple.

Under normal market conditions, stocks with PEG ratios close to one are considered equally priced.

#5. Management and ownership

You’ll want to address some key questions about the company’s management and ownership as part of your due diligence on a stock. Are the company’s founders still in charge? Or have management and the board brought in a slew of new faces? The age of the organization is an important consideration here, since younger businesses prefer to retain more of their founding members. Examine top managers’ consolidated bios to see what kind of diverse experience they have. This information is available on the company’s website or in Securities and Exchange Commission (SEC) filings.

Check to see if the founders and managers own a large proportion of the stock, as well as how much of the float is held by institutions. The percentage of institutional ownership indicates how much analyst coverage the company receives as well as the factors influencing trade volumes. Also, consider top management’s high personal ownership as a plus, and low ownership as a potential red flag. Shareholders are better served when the people running the business have a vested interest in the stock’s success.

#6. Examine the Balance Sheet

Many papers may be written on how to conduct a balance sheet analysis, but for our initial due diligence, a cursory examination will suffice. Examine the consolidated balance sheet of the company to see the total extent of assets and liabilities, paying particular attention to cash levels (the ability to cover short-term liabilities) and the amount of long-term debt retained by the company. A large amount of debt is not always a bad thing, and it is determined more by the company’s business model than anything else.

Some businesses (and industries as a whole) need a lot of money to get started, while others need little more than a few workers, some equipment, and a creative concept to get started. To determine how much positive equity the corporation has, look at the debt-to-equity ratio. You should then apply this to the debt-to-equity ratios of your rivals to bring the measure into context.

Try to find out why the “top line” balance sheet estimates of total assets, total liabilities, and stockholders’ equity vary so much from year to year. The footnotes that follow the financial statements, as well as the management discussion in the quarterly/annual report, will shed some light on the situation. The organization may be planning for a new product launch, amassing retained profits, or simply squeezing scarce capital resources. After reviewing recent benefit patterns, you should have a better understanding of what you’re seeing.

#7. Review the Stock Price History

At this point, you’ll want to know how long all types of shares have been trading, as well as the price action in both the short and long term. Is the stock price choppy and volatile, or smooth and consistent? This describes the type of profit experience that the average stock owner has had, which can influence future stock movement. Stocks that are continuously volatile appear to have short-term traders, which may bring additional risk factors to those investors.

#8. Dilution and Stock Options

Following that, you’ll need to delve through the 10-Q and 10-K reports. Quarterly SEC filings must provide information on all outstanding stock options as well as redemption expectations based on a range of potential stock prices. 2

Use this to help you understand how the share count could change depending on the price scenario. Although stock options can be a powerful motivator for workers, be wary of shady activities such as re-issuing “underwater” options or any formal inquiries into improper practices such as option backdating.

#9. Set your expectations

This due diligence phase is a sort of “catch-all” and necessitates some additional research. You’ll want to know what the consensus sales and profit forecasts are for the next two to three years, as well as long-term market trends and company-specific information about alliances, joint ventures, intellectual property, and new products and services. News about a new product or service on the horizon could have piqued your interest in the stock in the first place. Now is the time to dig deeper into it with the aid of all you’ve gathered so far.

#10. Dangers

Setting this critical piece aside until the end ensures that we are still stressing the risks associated with investing. Be certain that you are aware of both industry-wide and company-specific threats. Are there any unresolved legal or regulatory issues? Is management making decisions that will result in a rise in sales for the company? Is the business environmentally conscious? What long-term risks would it face if it embraces or rejects green initiatives? Investors should maintain a healthy devil’s advocate mentality at all times, visualizing worst-case scenarios and their future stock results.

In conclusion

After you’ve gone through these measures, you should be able to assess the company’s future profit potential as well as how the stock could fit into your portfolio or investment strategy. You’ll inevitably come across details that you’d like to learn more about. However, adhering to these guidelines can prevent you from overlooking information that may be critical to your decision.

Veteran investors will discard far more investment ideas (and cocktail napkins) than they will retain for further consideration, so never be afraid to start again with a new concept and a new venture. There are literally tens of thousands of businesses to choose from.

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