WHAT IS A DUE DILIGENCE REPORT? HOW TO CREATE ONE?
Due diligence reports are usually prepared by investors for the startup or any company they are interested in investing in. It is an official audit or investigation of an investment that is going to happen in future and the investor wants to make sure that everything about the venture is in place. It can be a thorough checking of the financial records, legal status and compliances, competition analysis, market analysis and the viability of the venture in times to come. An investor generally appoints someone for doing the process.
Mentioned below are a few steps to go about preparing a good Due Diligence report:
Step 1: Analysing the Capitalization of the Company A company’s market capitalization can provide an indication of how volatile the stock price might be, how broad the ownership might be, and the potential size of the company's target markets. For example, large-cap and mega-cap companies tend to have stable revenue streams and a large, diverse investor base, which can lead to less volatility. Mid-cap and small-cap companies, meanwhile, may only serve single areas of the market and typically have greater fluctuations in their stock price and earnings than large corporations.
Step 2: Revenue, Profit, and Margin Trends In analyzing the numbers, the income statement will have the company's revenue or the top line, net income or profit, which is called the bottom line. It's important to monitor any trends in a company's revenue, operating expenses, profit margins, and return on equity. Profit margin is calculated by dividing the company's net income by revenue. It's best to analyse profit margin over several quarters or years and compare those results to companies within the same industry to gain perspective.
Step 3: Competitors and Industries Information about competitors can be found in company profiles on most major research sites, usually along with a list of certain metrics already calculated for you. Performing due diligence on multiple companies in the same industry can provide investors with enormous insight as to how the industry is performing and what companies have a leading edge over the competition.
Step 4: Valuation Multiples There are many ratios and financial metrics that investors can use to evaluate companies. There's no one metric that's ideal for all investments, so it's best to utilize a combination of ratios to help generate a complete picture and lead to a more informed investment decision.
Step 5: Management and Share Ownership Research if the founders and executives hold a high proportion of shares and whether they have been selling shares recently. Consider high ownership by top managers as a plus and low ownership a potential red flag. Shareholders tend to be best served when those running the company have a vested interest in the performance of the stock.
Step 6: Balance Sheet If the figures for total assets, total liabilities, and stockholders' equity change substantially from one year to the next, try to determine the reason. Reading the footnotes that accompany the financial statements and the management's discussion in the quarterly or annual reports can shed light on what's happening with the company. The company could be preparing for a new product launch, accumulating retained earnings, or in a state of financial decline.
Step 7: Stock Price History Investors should research both the short-term and long-term price movement of the stock and whether the stock has been volatile or steady. Compare the profits generated historically and determine how they correlated with the price movement. Keep in mind that past performance does not guarantee future price movements. If you're a retiree looking for dividends, for example, you might not want a volatile stock price. Stocks that are continuously volatile tend to have short-term shareholders, which can add extra risk factors to certain investors.
Step 8: Stock Dilution Possibilities Investors should know how many shares outstanding exist for the company and how that number relates to the competition. Is the company planning on issuing more shares or further diluting its share count? If so, the stock price might take a hit.
Step 9: Expectations Investors should find out what the consensus of Wall Street analysts for earnings growth, revenue, and profit estimates are for the next two to three years. Investors should also research discussions of long-term trends affecting the industry and company-specific details about partnerships, joint ventures, intellectual property, and new products or services.
Step 10: Examine Long and Short-term Risks Be sure to understand both the industry-wide risks and company-specific risks that exist. Are there outstanding legal or regulatory matters? Is there unsteady management? Once you've completed the steps outlined above, investors should get a better sense of the company's performance and how it stacks up to the competition. From there you can develop your investment strategy.