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
- Financial ratios are an excellent way to gauge a company’s performance
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:
- 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
- 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
