Table of Contents
- What Is Due Diligence?
- Key Takeaways
- Understanding Due Diligence
- Types of Due Diligence
- Hard vs. Soft Due Diligence
- How to Perform Due Diligence for Stocks
- Due Diligence Basics for Startup Investments
- M&A Due Diligence
- What Exactly Is Due Diligence?
- What Is the Purpose of Due Diligence?
- What Is a Due Diligence Checklist?
- What Is a Due Diligence Example?
- The Bottom Line
What Is Due Diligence?
Let me explain due diligence directly: it's the process where you carefully examine and verify information before deciding on an action or agreement. In finance, this means checking financial records thoroughly before any transaction with another party.
Key Takeaways
You should know that due diligence is your systematic tool for analyzing and cutting down risks in business or investment choices. As an individual investor, you can do this on any stock using public info that's easy to find. This same approach works for other investments too. It involves looking at a company's figures, tracking them over time, and comparing to competitors. You'll see due diligence in other areas, like background checks for employees or reading product reviews.
Understanding Due Diligence
Due diligence became standard in the U.S. after the Securities Act of 1933, making securities dealers and brokers responsible for disclosing key info about what they're selling. If they didn't, they faced criminal charges. The law's creators knew full disclosure could expose dealers to unfair lawsuits for unknown facts, so they built in a defense: if you exercise due diligence in investigating and disclose what you find, you're not liable for undiscovered info.
Equity research analysts, fund managers, broker-dealers, individual investors like you, and companies eyeing acquisitions all perform due diligence. For you as an individual, it's optional, but broker-dealers must do it legally before selling securities.
Types of Due Diligence
Due diligence varies by purpose. In commercial due diligence, you look at market share, competitive positioning, future prospects, growth opportunities, supply chain, market analysis, sales and R&D pipelines, plus overall operations like management, HR, and IT. Legal due diligence ensures everything is compliant, covering litigation, IP rights, and proper incorporation. Financial due diligence audits statements for irregularities and solid footing. Tax due diligence checks exposure, back taxes, and reduction options.
Hard vs. Soft Due Diligence
You can categorize due diligence as hard or soft. Hard focuses on numbers from financial statements, using fundamental analysis and ratios to understand position and project futures—it spots red flags but can be skewed by optimistic sellers. Soft due diligence balances this by examining qualitative aspects like management quality, employee loyalty, and customer base, since numbers miss things like culture and leadership. Many M&A deals fail—70% to 90%—because the human side gets ignored.
How to Perform Due Diligence for Stocks
If you're an individual investor, follow these steps for due diligence on stocks, using info from quarterly/annual reports and financial sites. Start by analyzing the company's market capitalization to gauge volatility, ownership breadth, and market potential—large caps are stable, small caps fluctuate more. Next, check revenue, profit, and margin trends over time, comparing to industry peers for perspective.
Steps for Stock Due Diligence
- Step 3: Size up competitors and the industry by comparing profit margins and assessing leadership or growth.
- Step 4: Use valuation multiples like P/E, PEG, and P/S ratios, comparing to competitors over years.
- Step 5: Review management and ownership—high insider shares are good, recent sales might be a red flag.
- Step 6: Examine the balance sheet for assets, liabilities, debt levels, and cash flow changes.
- Step 7: Study stock price history for volatility and correlation to profits.
- Step 8: Check for stock dilution possibilities from new shares.
- Step 9: Look at analyst expectations for growth and industry trends.
- Step 10: Identify long- and short-term risks, including legal issues or market shifts.
Due Diligence Basics for Startup Investments
For startups, not all stock steps apply due to lack of history. Plan an exit strategy to recover funds if it fails. Consider partnerships to share capital and risk. Figure out a harvest strategy, watching for trends that could sink the business. Pick startups with promising products and increasing ROI over five years. Evaluate the growth plan for realism instead of past numbers.
M&A Due Diligence
In M&A, the acquirer analyzes the target's finances, growth potential, structure, practices, and shareholder value. Hard due diligence covers EBITDA, receivables, cash flow, capex, IP, and physical capital, plus reviewing statements, projections, markets, redundancies, litigation, antitrust, and third-party ties. Soft due diligence assesses cultural fit, employee motivation via compensation, and customer reactions to changes.
What Exactly Is Due Diligence?
Due diligence is your effort to gather and analyze info before deciding, often to assess investment risks by examining numbers, trends, and benchmarks.
What Is the Purpose of Due Diligence?
It reduces your risk exposure by ensuring full awareness of transaction details, like a broker providing reports to avoid liability.
What Is a Due Diligence Checklist?
It's an organized list covering ownership, assets, operations, ratios, value, processes, growth, management, and HR.
What Is a Due Diligence Example?
Think property inspections, M&A firm exams, or employee background checks.
The Bottom Line
Due diligence collects facts for informed decisions without legal liability, used in investments, broker duties, and acquisitions to minimize risks.
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