It is incredibly easy to make the wrong business decision due to inadequate information however, there are instances where the information needed to make the right decision is available, but the investor still makes the wrong decision because they did not examine the information properly. This article aims at providing useful tools and tips on performing due diligence on investment opportunities. Let’s dive right in.
Due diligence is defined by Merriam Webster as ‘research and analysis of a company or organization done in preparation for a business transaction’. Due diligence essentially is the act of carefully examining information about a business or an investment opportunity to determine whether to embark on the business venture or not.
The first step in performing due diligence on a company is getting to understand the company. At this stage, you are open minded. You do not have an opinion on the investment opportunity. The goal is to gather as much information on the company as possible. Factors to consider at this stage include the market capitalization, volatility and profit. Market capitalization is the value of a company traded on a stock market. It is calculated by multiplying the total number of shares by the share price. The higher the company’s capitalization, the less volatile the stock is. The investor can also analyze the profitability of the company over past several years as this will help determine the growth rate of the company. The growth rate can be used to forecast the future performance of a company.
The next step in performing due diligence is examining the company’s operations in relation to its competitors. To test this, one needs to assess the performance of other companies in the industry. By doing this, the investor has a full picture of the entity’s performance and can determine if the company is growing compared to the other players in the industry. Also, the Price Earning Ratio (P/E) ratio of the company needs to be calculated. This will help the investor determine if the stock of the company is a growth stock or a value stock. Growth stock is a share in a company that is anticipated to grow significantly over the average growth of the market, a common characteristic of a growth stock is a high P/E ratio. In contrast to this, a value stock is a security trading at a lower price than what the performance of a company indicates. A common characteristic of a value stock is a low P/E ratio.
The subsequent step is to review the ownership and management of the company. The management structure should be analyzed to determine if the company meets the local corporate governance requirements. The company’s statement of financial position also needs to be analyzed. This paints a picture of how the company is financed. The Gearing Ratio show the percentage of the company’s finances that are debt and equity. Highly geared companies tend to have more interest expenses as a result of their debt and there are also restrictive covenants associated with some debt agreements that limit the activities the company can embark on.
The company’s risk profile and appetite should be determined. This is important because most investors have a specific risk profile used in creating their investment portfolio. A new investment must reflect that risk appetite. In addition to all that have been said so far, socio-cultural factors also have a part to play in the determination of investment opportunities to take advantage of. Some investors have specified religious and cultural beliefs that will not allow them to invest in some companies. For example, a Muslim venture capitalist might not invest in a vineyard company that produces alcoholic beverages.
In addition to the above, there are specific considerations for performing due diligence on alternative investments. An example of this is getting third-party data reports from reputable services. Investors can also employ the services of a financial advisor. While performing due diligence, you should always be on the look out for material changes that may affect your decision.
The aim of this series was to provide investors with information about the alternative investment market. Please note that all investment decisions require sound decision making and skepticism. We hope you enjoyed the series and we were able to achieve our objective of enlightening all stakeholders of alternative investment opportunities
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Thank you for reading and look out for our next series!
Merriam Webster. (n.d.). due diligence. The Merriam-Webster.Com Dictionary. Retrieved March 4, 2021, from https://www.merriam-webster.com/dictionary/due%20diligence
Barnes, R. (2021, January 11). Due Diligence in 10 Easy Steps. Investopedia. https://www.investopedia.com/articles/stocks/08/due-diligence.asp
Smith, S. (2017, June 7). Top 7 Alternative Investment Due Diligence Considerations. FactRight. http://blog.factright.com/top-7-alternative-investment-due-diligence-considerations
Chen, J. (2020, May 1). Growth Stock Definition. Investopedia. https://www.investopedia.com/terms/g/growthstock.asp
Smith, T. (2020, November 26). Value Stock Definition. Investopedia. https://www.investopedia.com/terms/v/valuestock.asp