Due Diligence – basics

Due diligence is defined as investigation or audit that reasonable business and person undertakes before potential investment or before entering an agreement to confirm all facts. Most investor are doing research before buying a security but due diligence can be done by a seller who investigates buyer’s capability to complete the purchase. After the Securities Act of 1933 due diligence become common practice in United States when brokers and dealers became responsible for disclosing all relevant information about securities they were selling or they will otherwise be accountable and liable for prosecution. This put brokers into sensitive position where they could be unfairly prosecuted. In response creators of the Act set rule that says if broker performed due diligence when investigating companies whose securities they are going to sell and disclose that information to the public they are not held accountable.

Not only prospective investors perform due diligence but also broker dealers, fund managers, equity research analysts and companies that seek acquisition. While investors do due diligence voluntary, broker dealers are obliged to do it as stated in Securities Act of 1933. When companies plans to offers securities, before issuing final prospectus underwriter, issuing company and other parties involved such as accountants and attorneys will gather to discuss whether due diligence is exercised according to state and federal laws.

Performance of due diligence may vary depending on the security that is being researched. When doing DD it should take into consideration risk tolerance and investment goals of investor. However there are some questions that you need to answer in order to gain as much relevant information that you could. First thing you should check total value of the company because it is a good indication of stock’s volatility, diversity of investor base and size of target market. Size of the company, it’s stock price and revenues determine where the stock is going to trade. This brings us to “number research” meaning it is crucial that you do extensive financial research including revenue, profit, margin trends, ratios, financial metrics and balance sheet. Monitoring trends in revenues, operating expenses, profit margins and return on the equity is important part of the research process. Together with combination of various ratios and metrics it should be tracked over several quarters or years if possible. Balance sheet provides you information about company’s assets, liabilities and cash available; showing is company capable to pay short term expenses and debts. All the parameters should be compared with competitors in the same industry and get a bigger picture. This way it s easy to determine if company is a leader in the field and what is the size and growing potential of the industry.

Stock price movement should be analyzed, both short term and long term as well as correlation between stock price movement and profit. Pay attention to number of shares outstanding and any plans for future issuing of shares and subsequent dilution. When it comes to company’s management you should check their experience and area of expertise and how much shares they hold. If they have high ownership it is a good sign because it means they have vested interest in the company’s and stock performance.

In the end it is important to be aware of company specific and industry wide risks and how that fits in your investment style and amount of risk you are willing to take.

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