Finance and markets

Fundamentals of the Due Diligence Process

Due diligence (DD) is the process of detailed research and/or appraisal, which takes place before making a decision and focuses on minimizing risks and/or estimating true commercial value. It is the investigation, audit, or review that must be performed to validate the facts.

Some general examples include:

  • Before buying a property: visit and inspect the site and surroundings; analyze the market trends to negotiate the actual market price
  • Before buying a product online: read the product description, feature details, customer reviews – compare all info to other products/brands

Kinds of Due Diligence:

Corporate due diligence is exercised by:

  • Companies planning to acquire or merge with other entities
  • Fund managers and equity research analysts – must base their decisions on a diligent research
  • Individual investors – conduct analysis on all their trading (voluntarily)
  • Brokers and dealers – conduct thorough research for any instrument (legally obliged)

DD when investing in a listed company:

Required information is most readily available through the financial statements and/or other publicly available data.

  • Study the company’s capitalization:
    • Financed by owners (equity) and/or by creditors (debt)
    • Market cap can indicate the level of price volatility, business quality (attractiveness), and size
    • ‘Large-cap’ companies have a stable revenue stream, large investor base, a less volatile stock price
    • ‘Small-cap’ and ‘Mid-cap’ companies can be more unstable in their share prices and revenue streams
  • Revenue trends:
    • It is important to analyze the P&L trends in their revenue, operating, and other expenses.
    • Profit margins benchmark – historical (horizontal) and sector analysis
  • Industry competitors:
    • The performance of a company should be gauged against competitors
    • Review market share split – is the company a market leader or is it still growing
    • Conduct detailed research on the key competitors – economic moat, financials, management, etc.
  • Key valuation metrics:
    • Financial ratios are an excellent way to gauge a company’s performance
      • Earnings per share [EPS] – shows the financial health
      • Price-Earnings to Growth [PEG] Ratio – close to 1 means fair value
      • Debt to Equity Ratio – analyzes financial leverage
      • Liquidity Ratio – analyzes solvency
    • Balance Sheet:
      • The company could be going through a financial crisis, future expansion, business restructuring
      • Scrutinizing disclosures can provide deep insight into the company’s affairs

DD in Mergers & Takeovers:

Acquiring another business requires a lot of research, analysis, forecasting, and diligence. Generally, it involves gathering all the necessary information about the target’s financial performance, financial position, operations, and other prospects. DD addresses the following:

  • Would the transaction benefit the company
  • Is the offered cost reasonable
  • What are the SWOT aspects of the target and how to address them

The process requires two kinds of Due diligence:

  1. Hard DD:
  • The buyer performs DD by analyzing the target’s costs, revenues, structures, benefits, assets, and liabilities
  • Hard due diligence is all about lawyers, negotiators, professional valuers, risk analysts, and accountants
  • It mainly focuses on earnings, interest, taxes, profit before tax, receivables, liquidity, etc
  • Some hard due diligence activities include:
    • Financial statements audit
    • Future performance projections
    • Market trends analysis
    • Customer and vendor analysis
    • Review of earnings potential and opportunities
  1. Soft DD:
  • Non-quantitative analysis of business performance drivers
  • Covers internal organizational culture, employee relationships, corporate culture, management, etc.
  • Focuses on how well a new workforce can integrate with the existing culture of the acquiring entity.
  • Some soft due diligence activities include:
    • Measure employee motivation and skills
    • Review compensation packages and incentive plans
    • Evaluate the organizational culture
    • Estimate employee churn – post-transaction

Published by ARP Management