Due diligence: a fancy word for doing your homework
17 March 2021
One term you might hear around investing is ‘due diligence’. This is the research you do to decide whether you’re going to put money into an investment or not. You can think of it as your investment homework—when you do due diligence, you’re doing your homework to help get you ready to invest.
Due diligence is a really personal matter—and if you’re investing, you probably already do it! It can range from reading a company description, to poring over annual reports and financial information. And the way you do due diligence is going to be personal as well. What makes a company good for one person may not be for another.
It’s also good to remember that due diligence is never going to give you a 100% accurate answer because you just can't predict the future. What due diligence can do is help you make an informed choice about what you’re investing in, and how much risk you’re taking.
Like most things in investing, the specific approach is up to you. But here are a few things you might want to think about when doing your homework before you invest. These are just some things to get you started—there’s a lot more due diligence you can do, but this blog will just cover a few basics to get you thinking.
What does Google tell you?
This might seem simple, but it can be a really good place to start your due diligence. Put the company’s name into Google and see what comes up. If there’s been any big news lately (good or bad), it will probably be at the top of the page. If they just announced record profits or losses, you might see those. If they got caught up in a scandal, you might see that.
You can also search for information about the company’s financials. If you Google the company’s name with terms like ‘share price’, you might find things like its market capitalisation and price-to-earnings ratio. These numbers give you a view of two things: how much the market thinks the company is worth (the market capitalisation), and how much the market thinks the company is worth divided by how much profit it earns.
A high price-to-earnings ratio could mean that a company's stock is over-valued, or else that investors are expecting high growth rates in the future. A low price-to-earnings ratio suggests that the market expects less growth in the future or might indicate that the current stock price is low relative to earnings. This can be a useful starting point for your due diligence, but should be considered alongside other things.
What does the future look like?
This is not something you can look up. Rather, this is about you taking a view on what the future might look like. There are many questions you may want to think about. You could ask questions like:
Is the company you’re looking at going to be around in 10-15 years?
Will they be able to adapt and thrive as the world changes, or will they struggle?
What are the risks?
Are they being disrupted by new competitors and technology?
For example, imagine if you’d invested in a big horseshoe company in 1919, believing that horses would continue to be the main mode of transport. By 1935, far fewer people were riding horses—instead, they were in cars! What do you think today’s version of a horseshoe company is? And what’s today’s version of a car company?
What’s the company story?
Every company has a story. A good way to find a company’s story is to track down its annual report. This will usually be on its website and the share exchange. You can also quickly track it down by searching its name and the term “annual report.”
Combine this with news stories about the company. You might find answers to some questions like:
What systems and values does it have in place?
Does it invest in people?
Does it take steps to grow?
What’s its culture like?
Are they open to new ideas?
Do they have a history of achieving what they’ve set out to achieve?
You can find their version of their story at the beginning of the annual report. Have a read, and ask yourself if it resonates with you. Does it make sense? Do you believe it? You might like to think about whether there are any gaps in the story.
You can also take a look at who’s in charge of the company. You could check the company or exchange’s website, and Google their names. What experience does the management and board have? Are they personally invested in the company? How are they compensated and incentivised?
What is its impact on the world?
More and more companies are doing integrated reporting. This is when they report the amount of money they spent and earned, but also report their impacts on other areas and stakeholders, such as the environment. You might want to check to see whether this company does integrated reporting—and if it does, you might consider whether you’re happy with the results.
Remember, investing in a company is a vote of confidence in its direction, and a signal that you want it to be around in the future. And that’s not just the company itself. It’s also the things the company does, the people it works with, and the things it sells.
What information do you have?
Everyone has some kind of expertise. You might have a job in the same industry as the company you’re investing in. You might read a lot about the company and its industry. You might even be a customer and buy their products or use their services regularly.
Do your own research—these insights can be super valuable, and usually all you need to do to get them is to ask.
Make a decision!
Once you’re happy with the information you have, you may be ready to make a decision. Do you invest, or not? Or, do you do some more research? It’s a choice based on what you believe, given the information you’ve found through doing due diligence.
And remember, no matter how much due diligence you do, you’re still taking a risk. Due diligence is about figuring out what the risks are, and making a call as to whether you’re comfortable with them.
Check back in
Once you’ve made your decision, it may be a good idea to check back in with the company every now and then. Whether you invested or not, this can be a good way to test how accurate your educated guess was. Did things play out the way you thought they would? Did you miss something big? Checking back in regularly may help to improve your due diligence in the future.
So there you go! You’ve just gone through the due diligence process. Not only do you have more information, but you’ve probably learned a few things about how these companies work. Not a bad deal, all in all.
Ok, now for the legal bit
Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written. You should consider seeking independent legal, financial, taxation or other advice when considering whether an investment is appropriate for your objectives, financial situation or needs.