Due diligence the investigation or audit of a potential investment. Due diligence serves to confirm all material facts in regards to a sale. - Investopedia
'I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.'
When you are going to perform due diligence on a company you first of all want to get a good idea about the company and their background. Here are a couple of things to look at in order to gain a good understanding of the company:
- What does the company do? - Is it a service company or does it produce a product? This is useful simply to get an idea of how the company operates or should operate.
- What are the company's inputs? - What materials does the company require to produce its product/services? For products this can be direct inputs such as iron ore, concrete, wood etc. while for services this can include human capital constraints such as skilled programmers, accountants, financial planners etc. This is important to understand as it allows you to look at the broader market which the company operates in. If for example a company primarily operates as a grain exporter then a forecast drought can have a drastic effect on the company's revenue and future earnings.
- Who is the company's management? - This can be fairly simple to find as this will be usually listed on the company website or on the exchange. It's worthwhile to know the backgrounds of management as it provides insight into how the company is likely to perform. A management team with a poor record is much like a sporting coach with a bad record. Likewise you would expect that management’s skills and expertise have an overlap with the company's primary product. A firm producing Iron Ore but with a management team comprised solely of staff with a background in Marketing is not likely to fill me with confidence.
- What is the company's market capitalization? Market capitalization is the total value of the company's listed shares and is calculated by multiplying the total outstanding shares by the current share price. This can provide a general idea of how large a company is and how many markets that the company operates in. For instance, a large-cap company is likely to be a multinational operating in many markets, while a small-cap is likely to be a regional player. Additionally, large-cap companies are likely to be broadly owned (ie: have many individual investors) and less volatile.
- Who are the company's competitors? - It’s highly likely that any company operates in a market with competitors, whether local or international. If a company operates in a market with many competitors, management strategy is likely going to focus on differentiation or cost control.
- Do substitutes exist for the company’s product/service? - A substitute is simply another product/service which can be used instead of the company's product/service. The simplest example of this is margarine vs butter, and represents another source of competition which may be overlooked.
