Due diligence: a fancy word for doing your homework
You might’ve heard the term due diligence. This is the research you do to make a decision about whether you’re going to invest in something or not.
An easier way to think about it is to think of it as your investment homework—when you do due diligence, you’re doing your homework to 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.
What does Google tell you?
This might seem simple, but it’s 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 almost certainly be at the top of the page. If they just announced record profits or losses, you’re going to see those. If they got caught up in a scandal, you’re going to see it.
You can also search for information about the company’s financials. If you Google the company’s name and add terms like “annual report” you can find things like the company’s market capitalisation and price-to-earnings ratio. These things give you a very broad overview of the company.
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. 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 the 2019 version of a horseshoe is? And what is the 2019 version of a car?
What’s the company story?
Every company has a story. Doing a Google search and reading annual reports can help give you an idea of where a company’s come from and where it’s heading in the future. 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 also take a look at who’s in charge of the company. Check the company or exchange’s website, and Google their names. What experience does the management 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, ask yourself if 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!
It’s time to make a decision. You’ve gathered information, you’ve had a think about the company, and now it’s time to make a choice. 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, you should check back in with the company every now and then. Whether you invested or not, this is 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? This is a great way to improve your due diligence and become an even better investor, so make sure you tick this final box.
So there you go! You’ve just gone through the due diligence process. Not only do you have more information, 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.