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Due diligence

Due diligence is defined as an investigation of a potential investment (such as a stock) or product to confirm all facts. These facts can include such items as reviewing all financial records, past company performance, plus anything else deemed material. For individual investors, doing due diligence on a potential stock investment is voluntary, but recommended.

Step 1: Company Capitalization

The first step is for you to form a mental picture or diagram of the company you're researching. This is why you'll want to look at the company's market capitalization, which shows you just how big the company is by calculating the total dollar market value of its outstanding shares.

Step 2: Revenue, Margin Trends

When you begin looking at the financial numbers related to the company you're researching, it may be best to start with the revenue, profit, and margin trends.

Step 3: Competitors and Industries

Now that you have a feel for how big the company is and how much money it earns, it's time to size up the industries it operates in and with whom it competes. Compare the margins of two or three competitors. Every company is partially defined its competitors. Just by looking at the major competitors in each line of the company's business (if there is more than one), you may be able to determine how big the end markets are for its products.

Step 4: Valuation Multiples

Now it's time to get to the nitty-gritty of performing due diligence on a stock. You'll want to review the price/earnings to growth (PEG) ratio for both the company you're researching and its competitors. Make a note of any large discrepancies in valuations between the company and its competitors

Step 5: Management and Ownership

As part of performing due diligence on a stock, you'll want to answer some key questions regarding the company's management and ownership. Is the company still run by its founders? Or has management and the board shuffled in a lot of new faces? The age of the company is a big factor here, as younger companies tend to have more of the founding members still around. Look at consolidated bios of top managers to see what kind of broad experiences they have.

Step 6: Balance Sheet Exam

Many articles could easily be devoted to how to do a balance sheet review, but for our initial due diligence purposes, a cursory exam will do. Review your company's consolidated balance sheet to see the overall level of assets and liabilities, paying special attention to cash levels (the ability to pay short-term liabilities) and the amount of long-term debt held by the company.

Step 7: Stock Price History

At this point, you'll want to nail down just how long all classes of shares have been trading, as well as both short-term and long-term price movement. Has the stock price been choppy and volatile, or smooth and steady? This outlines what kind of profit experience the average owner of the stock has seen, which can influence future stock movement.

Step 8: Stock Options and Dilution

Next, you'll need to dig into the 10-Q and 10-K reports. Quarterly SEC filings are required to show all outstanding stock options as well as the conversion expectations given a range of future stock prices.2

Step 9: Expectations

This due diligence step is a sort of "catch-all," and requires some extra digging. You'll want to find out what the consensus revenue and profit estimates are for the next two to three years, long-term trends affecting the industry, and company-specific details about partnerships, joint ventures, intellectual property, and new products and services. News about a product or service on the horizon may be what initially interested you in the stock.

Step 10: Risks

Setting this vital piece aside for the end makes sure that we're always emphasizing the risks inherent with investing. Make sure to understand both industry-wide risks and company-specific ones. Are there outstanding legal or regulatory matters? Is management making decisions that lead to an increase in the company's revenues

? Is the company eco-friendly? What kind of long-term risks could result from it embracing/not embracing green initiatives? Investors should keep a healthy devil's advocate mindset at all times, picturing worst-case scenarios and their potential outcomes on the stock.