A Guide to Due Diligence
It is imperative to remember that investments into any emerging growth company presents a high degree of risk and investors can potentially loose up to their entire investment!
So you find yourself interested in investing in the stock market. You may find yourself looking to diverse your portfolio or you might be looking to test the waters of investing in stocks to allow your hard earned money to work for you. Regardless, the stock market or a particular company has tickled your interest. At this moment, thoughts begin to rush into your head. Questions like; How do you learn more about the company? How can I tell if a company is a good investment or not? How much money should I invest? Before exasperation sets in, take a deep breath and relax.
What needs to happen is a thorough due diligence. This will allow you the confidence of knowing that you have adequately looked into the company and are satisfied that you can make an intelligent decision to proceed with the investment or not. Of course, in order to do an effective due diligence one needs to have information. Thankfully, we live in an age of access to an endless amount of information and the government (namely the Securities and Exchange Commission) also works diligently by making sure the investor has access to audited information to allow investors to make an educated decision.
There have been countless books and articles written on how to pick a stock. That is not in the purview of this article. Here, we will focus on the due diligence process. Doing due diligence means that you have invested the time and effort to learn the necessary details of the company to be able to make educated decisions on wether to invest.
So lets get started on doing some due diligence.
- Internet - Believe it or not, a great place to start is to review the company website. This should be able to give you a good understanding of what the company does and where its focuses are. Additionally, there is generally useful information on company management. Feeling comfortable with management is important.
- Another thing is to do an online search on the company and its’ management. You may learn things that will lead you to have confidence, or you may learn things that are a cause of concern. You will never know until you do the research. It may be helpful to conduct searches on more than one search engine just to make sure you didn’t miss anything.
- While you are doing internet searches, take the time to look for competition. This can help you asses the competition in the marketplace. If, there is competition, it can very useful to understand the size, profitability, stock price, longevity, etc.
Up to this point in the due diligence process you should have gained much knowledge. What the company does and what their current focus is on should be revealed. You have also had the opportunity to learn more about the people running the company. Equally important is that you have done some internet background checks on the company, management and competition. All in all, a solid start!
Before moving on to the next due diligence tasks, we would like to take a moment to introduce you to the SEC (Securities and Exchange Commission) and the valuable work they do. After all, the SEC is there to protect investors. They do this in many and various ways. As, the full scope of their activities is a matter for another (very lengthy) discussion, we will focus on the areas associated with helping investors to obtain needed and valuable information prior to deciding on wether to invest or not.
The SEC requires that all public companies divulge a tremendous amount of information frequently. As an investor, this is an incredible asset!!! To make things even better, the information divulged must be verified by an accredited independent auditor who is closely monitored (Independent auditors are subject to regular and surprise audits of their practice by FINRA, another government organization). With this level of oversight, the investor can feel comfortable that the information he is getting is adequate. While we recognize these safeguards that have been in place don’t always work (Enron, Madof, etc.), they are exceptions and not the rule.
Let’s take a moment to familiarize ourselves with the reports that are most commonly file by the company to the SEC. These filings can all be found at SEC.gov. These filings include:
10-K- annual report: This report will not only have the financial statements for the full year, but also a reasonably detailed summary of the company's business operations, risks, and accounting policies. This report is filed by the company annually.
10-Q- quarterly report: Not as complete as an annual report, it will still include financial statements, and more details about financial performance than may be included in press releases or conference calls. These reports must be filed on a quarterly basis.
8-K- report of a material event: If something big happens to a company, they are required to file an 8-K. While these are often just repeats of press releases, every once in a while you'll find a nugget of information that wasn't delivered to the press.
DEF-14A- proxy statement: Want to know who's on the board and how much stock they own? Want to know how much the CEO makes, or what kind of options the company gives out? This is the place to look.
S-1 -- prospectus: Filed by companies before share offerings, these forms somewhat resemble 10-Ks. They generally have detailed information about the business and its finances.
Now that we have reviewed what the common company filings are, we urge each reader to visit the SEC website and do a search on a company of interest. Look for one of the reports mentioned above and open it up and start to read. As you begin to read, it quickly becomes evident that the shorthand and style of the writing appears intimidating. Once again, take a breath, its not that bad once you know what to look for. Once you do, your due diligence can continue.
The two filings that give you the most information on a company are the 10K and S-1. Consequently, we will focus on these two. Each of these two filings will have a table of contents. We will now discuss some of the more important areas and what it may contain.
Risk Factors - This section reviews the risks associated with the company. Make sure to understand both industry-wide risks and company-specific ones. Are there outstanding legal or regulatory matters, or just a spotty history with management? Investors should keep a healthy devil's advocate going at all times, picturing worst-case scenarios and their potential outcomes on the stock.
Stock Options and Dilution Possibilities - Next, investors will need to dig into the 10-Q and 10-K reports. Quarterly SEC filings are required to show all outstanding stock options as well as the conversion expectations given a range of future stock prices. Use this to help understand how the share count could change under different price scenarios. Especially take notice of any specific events that may cause a sharp dilution of shares (like a convertible note or employee stock plan).
Description of Business - This section should outline the history of the company and what its current business plan is. Read this thoroughly. Make sure the plan is something you believe is realistic and obtainable. It will also allow you to see overtime the companys ability to achieve its expectations.
Legal Proceedings - This section will inform you of any legal proceedings that are currently being brought against the company. These proceedings (if any) are a matter of public record. While a minor legal proceeding may mean little, a large litigation may be of more concern.
Management and Share Ownership - Is the company still run by its founders? Or has management and the board shuffled in a lot of new faces? The age of the company is a big factor here, as younger companies tend to have more of the founding members still around. Look at consolidated bios of top managers to see what kind of broad experiences they have; this information may be found on the company's website or on SEC filings.
Also look to see if founders and managers hold a high proportion of shares, and what amount of the float is held by institutions. Institutional ownership percentages indicate how much analyst coverage the company is getting as well as factors influencing trade volumes. Consider high personal ownership by top managers as a plus, and low ownership a potential red flag. Shareholders tend to be best served when the people running the company have a stake in the performance of the stock.
Competitors and Industries - Now that you have a feel for how big the company is and how much money it earns, it's time to size up the industries it operates in and who it competes with. Compare the margins of two or three competitors. Every company is partially defined by who it competes with. Looking at the major competitors in each line of business (if there is more than one) may help you nail down just how big the end markets for products are.
Information about competitors can be found in company profiles on most major research sites, usually along with their ticker or direct comparisons that let you review a list with certain metrics filled in for both the company you're researching and its competitors. If you're still uncertain of how the company's business model works, you should look to fill in any gaps here before moving further along. Sometimes just reading about some of the competitors may help to understand what your target company actually does.
Executive Compensation - In this section you can look at the compensation packages for executives. It is up to you if you feel these levels of compensation of appropriate but if an executive is taking a large percentage of the expenses as salary, you might want to think twice.
Experts - Who are the attorneys, accountants and auditors working with the company. You can check on these individuals through their respective professional organizations. Normally you will find qualified professionals that obey all the rules. Occasionally, sometimes you may find yourself looking at people with blemishes on their record. Would you be comfortable with that?
Financials - Many articles could easily be devoted to just the balance sheet, but for our initial due diligence purposes a cursory exam will do. Look up a consolidated balance sheet to see the overall level of assets and liabilities, paying special attention to cash levels (the ability to pay short-term liabilities) and the amount of long-term debt held by the company. A lot of debt is not necessarily a bad thing, and depends more on the business model than anything else. Some companies (and industries as a whole) are very capital intensive, while others require little more than the basics of employees, equipment and a novel idea to get up and running. Look at the debt-to-equity ratio to see how much positive equity the company has going for it; you can then compare this with the competitors to put the metric into better perspective.
If the "top line" balance sheet figures of total assets, total liabilities and stockholders' equity change substantially from one year to the next, try to determine why. Reading the footnotes that accompany the financial statements and the management's discussion in the quarterly/annual report can shed some light on the situation. The company could be preparing for a new product launch, accumulating retained earnings or simply whittling away at precious capital resources. What you see should start to have some deeper perspective after having reviewed the recent profit trends.
Capitalization of the Company - It really helps to form a mental picture or diagram of a newly researched company and the first step is to determine just how big the company is. The market capitalization says a lot about how volatile the stock is likely to be, how broad the ownership might be and the potential size of the company's end markets. For example, large cap and mega cap companies tend to have more stable revenue streams and less volatility. Mid cap and small cap companies, meanwhile, may only serve single areas of the market, and may have more fluctuations in their stock price and earnings.
No judgments should be made at this step; we are just accumulating information that will set the stage for everything to come. When you start to examine revenue and profit figures, the market cap will give you some perspective.
Expectations - This is a sort of a "catch all", and requires some extra digging. Investors should find out what the consensus revenue and profit estimates are for the next two to three years, long-term trends affecting the industry and company specific details about partnerships, joint ventures, intellectual property, and new products/services. News about a product or service on the horizon may be what initially turned you on to the stock, and now is the time to examine it more fully with the help of everything you've accumulated thus far.
Use Of Proceeds - This section is not normally included in the annual 10k but rather the S-1 where the company is registering shares to raise capital. How much money the company is trying to raise and what they intend to do with these additional funds. This knowledge can give you a great understanding as to the direction the company is going.
Once you've completed these steps you should be able to feel comfortable that you understand what the company has done so far, and what its future intentions are. Inevitably you'll have specifics that you will want to research further, but following these guidelines should save you from missing something that could be vital to your decision.
As for how much you should invest?......Always remember that investment is a risk and you stand a chance to lose all or some of your money. So invest at a level that makes sense for your individual circumstances.