Saturday, May 28, 2016

Due Diligence In 10 Easy Steps



 Courtesy : Investopedia

You sit down at your computer with a fresh cocktail napkin or sticky note that has a single ticker scribbled across it - it's a ticker you've never researched before, but something (or someone) has piqued your interest. This article will discuss 10 steps you should take on your first tour through a new stock. This due diligence allows you to gain essential information and vet out a possible new investment.
The steps are organized so that each new piece of information will build upon what has been previously learned. In the end, following these steps will give you a balanced view of the pros and cons of your investment idea, and allow you to make a rational, logical decision.

Step 1 - The Capitalization of the Company 
 
It really helps to form a mental picture or diagram of a newly researched company and the first step is to determine just how big the company is. The market capitalization says a lot about how volatile the stock is likely to be, how broad the ownership might be and the potential size of the company's end markets. For example, large cap and mega cap companies tend to have more stable revenue streams and less volatility. Mid cap and small cap companies, meanwhile, may only serve single areas of the market, and may have more fluctuations in their stock price and earnings. No judgments should be made at this step; we are just accumulating information that will set the stage for everything to come. When you start to examine revenue and profit figures, the market cap will give you some perspective.

Step 2 - Revenue, Profit and Margin Trends
 
When beginning to look at the numbers, it may be best to start with the revenue, profit and margin (RPM) trends.Look up the revenue and net income trends for the past two years at a general finance . These should have links to quarterly (for the past 12 months) and annual reports (past three years). A quick calculator check could be done to confirm the price-to-sales (P/S) ratio and the price-to-earnings (P/E) ratio. Look at the recent trends in both sets of figures, noting whether growth is choppy or consistent, or if there any major swings (such as more than 50% in one year) in either direction.
Margins should also be reviewed to see if they are generally rising, falling, or remaining the same. This information will come into play more during the next step. 

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 who it competes with. Compare the margins of two or three competitors. Every company is partially defined by who it competes with. Looking at the major competitors in each line of business (if there is more than one) may help you nail down just how big the end markets for products are.Information about competitors can be found in company profiles on most major research sites, usually along with their ticker or direct comparisons that let you review a list with certain metrics filled in for both the company you're researching and its competitors. If you're still uncertain of how the company's business model works, you should look to fill in any gaps here before moving further along. Sometimes just reading about some of the competitors may help to understand what your target company actually does. 

Step 4 - Valuation Multiples
 
Now it's time to get to the nitty-gritty of P/Es, price/earnings to growth (PEGs) ratio, and the like - for both the company and its competitors. Note any large discrepancies between competitors for further review. It's not uncommon to become more interested in a competitor during this step, which is perfectly fine, but still look to follow through with the original due diligence while noting the other company for further review down the road.

P/E ratios can form the initial basis for looking at valuations. While earnings can and will have some volatility (even at the most stable companies), valuations based on trailing earnings or on current estimates are a yardstick that allows instant comparison to broad market multiples or direct competitors. Basic "growth stock" versus "value stock" distinctions can be made here along with a general sense of how much expectation is built into the company. It's generally a good idea to examine a few years' worth of net earnings figures to make sure most recent earnings figure (and the one used to calculate the P/E) is normalized, and not being thrown off by a large one-time adjustment or charge.
Not to be used in isolation, the P/E should be looked at in conjunction with the price-to-book (P/B) ratio, the enterprise multiple and the price-to-sales (or revenue) ratio. These multiples highlight the valuation of the company as it relates to its debt, annual revenues, and the balance sheet. Because ranges in these values differ from industry to industry, reviewing the same figures for some competitors or peers is a key step. Finally, the PEG ratio brings into account the expectations for future earnings growth, and how it compares to the current earnings multiple. Stocks with PEG ratios close to 1 are considered fairly valued under normal market conditions.

Step 5 - Management and Share 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; this information may be found on the company's website or on exchange filings.
Also look to see if founders and managers hold a high proportion of shares, and what amount of the float is held by institutions. Institutional ownership percentages indicate how much analyst coverage the company is getting as well as factors influencing trade volumes. Consider high personal ownership by top managers as a plus, and low ownership a potential red flag. Shareholders tend to be best served when the people running the company have a stake in the performance of the stock. 

Step 6 - Balance Sheet Exam
 
Many articles could easily be devoted to just the balance sheet, but for our initial due diligence purposes a cursory exam will do. Look up a 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. A lot of debt is not necessarily a bad thing, and depends more on the business model than anything else. Some companies (and industries as a whole) are very capital intensive, while others require little more than the basics of employees, equipment and a novel idea to get up and running. Look at the debt-to-equity ratio to see how much positive equity the company has going for it; you can then compare this with the competitors to put the metric into better perspective. 

If the "top line" balance sheet figures of total assets, total liabilities and stockholders' equity change substantially from one year to the next, try to determine why. Reading the footnotes that accompany the financial statements and the management's discussion in the quarterly/annual report can shed some light on the situation. The company could be preparing for a new product launch, accumulating retained earnings or simply whittling away at precious capital resources. What you see should start to have some deeper perspective after having reviewed the recent profit trends. 

Step 7 - Stock Price History
 
At this point you'll want to nail down just how long all classes of shares have been trading, and 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. Stocks that are continuously volatile tend to have short-term shareholders, which can add extra risk factors to certain investors.

Step 8 - Stock Options and Dilution Possibilities
 
Next, investors will need to dig into the exchange  filings  to see all outstanding stock options as well as the conversion expectations given a range of future stock prices. Use this to help understand how the share count could change under different price scenarios. While employee stock options are potentially a powerful motivator, watch out for shady practices like re-issuing of "underwater" options or any formal investigations that have been made into illegal practices like options backdating. 

Step 9 - Expectations
 
This is a sort of a "catch all", and requires some extra digging. Investors should 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/services. News about a product or service on the horizon may be what initially turned you on to the stock, and now is the time to examine it more fully with the help of everything you've accumulated thus far.

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

Conclusion
 
Once you've completed these steps you should be able to wrap your mind around what the company has done so far, and how it might fit into a broad portfolio or investment strategy. Inevitably you'll have specifics that you will want to research further, but following these guidelines should save you from missing something that could be vital to your decision. Veteran investors will throw many more investment ideas (and cocktail napkins) into the trash bin than they will keep for further review, so never be afraid to start over with a fresh idea and a new company. There are literally tens of thousands of companies out there to choose from!

76 comments :

  1. Dear VP, have been holding Panacea for a long time at Rs.130/ per share. Now this year results have shown good recovery signs. Do u suggest averaging at this price?

    ReplyDelete
  2. Hi VP Sir, Your recommendation IL&FS Engineering posted very good result. Also they decided to issue Preference Shares of Rs. 100 each on preferential basis for an amount up to Rs. 500 Crore. Your valuable views please.

    ReplyDelete
    Replies
    1. It is because of Rs.85 Cr other income. Company's plan to raise Rs.500 Cr is expected to speed up execution.

      Delete
    2. Sir, generally what is considered as other income? 85 crore is a big amount and just want to know how come in some quarters hardly any amount is mentioned and some quarters like this is a huge amount?

      Delete
  3. sir

    please share your view on skipper limited . dont you think it is undervalued ?

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  4. Sir. your views on Ramky infra result.

    ReplyDelete
    Replies
    1. Sir short and sweet reply ;) lot of users on mmb stating this is operators stock and company clear axis bank loan by taking some long term loan. I am not expert reading detailed financials hence wanted to clear doubts.

      Delete
    2. Nobody compelling anyone to buy or sell a stock . One should act on one's own assessment . Why their short term loan reduced and long term loan ( on a consolidated basis) increased is explained by company official itself in today's CNBC Interview , link of the same below :

      http://www.moneycontrol.com/news/results-boardroom/hopefulmaintaining-earnings-momentumfy17-ramky-infra_6790621.html

      Delete
  5. Dear VP,

    Thank you for mentoring and providing highly informative article. My sincere appreciation for your continued guidance. Wish you healthy life!

    ReplyDelete
  6. Sir you views on MIC ELECTRONICS RESULTS ITS A SHOCKER YOUR VIEWS SIR WHETHER YOU WILL HOLD OR SELL

    ReplyDelete
    Replies
    1. Not a shocker for me,write off all remaining skeletons related with old business is a welcome step to clean the slate.

      Delete
    2. But I don't see any positive in the result as well. EBITDA would have been negative if they had not understated the Interest to be paid due to banks recognizing as NPA. Banks considering the dues as NPA is also a negetive. Plus somewhere in the result they have mentioned that they had liquidity crunch. Even if you show confidence in the result, I doubt recovery is going to be 3 quarters beyond. Also this amount of obsolete inventory was too huge an amount compared to revenues and OPM they are dealing with. If this happens every 4-5 years then all the profits will keep getting eroded.

      Delete
    3. This stock suggested @ Rs.4 .When buying a stock at that price I am not expecting a balance sheet quality equal to that of TCS or Infosys.

      Delete
    4. Hello sir, would you recommend the stock at this level for 2-3 years time frame ?

      Delete
    5. Not recommending any stock here which is against SEBI rules . Based on some recent verdicts from SEBI in this matter , I believe ,it is better to avoid any BUY/HOLD/ SELL recommendation even as reply for comments is necessary to comply with SEBI rules .In order to follow the rules ,avoiding such recommendations here.

      Delete
  7. Sir, alps industries management note declared with results are looking good.spinning unit also reopened. Looks like company is heading in the right direction

    ReplyDelete
    Replies
    1. Yes , they have settled a long disputed derivative transaction related issue recently. See the details below.

      http://www.bseindia.com/xml-data/corpfiling/AttachHis/E3B68D48_F638_4684_B0A1_B80BE2595392_170721.pdf

      Delete
  8. Dear Sir,

    I've been following your blog from few months.. I'm a biginner in stock market.. Could you plz share your view on ortin labs and saregama.. Thanks in advance

    ReplyDelete
  9. Sir, could you please share your opinion on Meghmani Organics. The company has posted very good result during March quarter too and with shutdown in chinese plants, future is looking better poised. Your views sir ?
    Have a nice day

    ReplyDelete
    Replies
    1. Not tracking it. Recently Chinese shut down is used as a catalyst to prop up the stock price of companies from different sectors including chemicals. Before acting on such news it is always better to ascertain the nature of closure - whether it is temporary or permanent .

      Delete
  10. Pls share view on ipca labs under current headwinds. Do you see anything positive with the company and mgmt

    ReplyDelete
    Replies
    1. 1.5-2 years is the normal time frame to resolve USFDA issues

      Delete
  11. Hello, Sir do you remember suggesting ALPS INDUSTRIES might be a good turnaround. The company just reported a huge profit with solid EPS...has the time come in it

    ReplyDelete
    Replies
    1. Huge profit in this quarter is due to exceptional income in this quarter . What is positive in my view already posted above. Study self and take a call.

      Delete
  12. VP sir, Your view on Zicom Electronic Security after huge fall. Can we add this one in small quantities.

    ReplyDelete
    Replies
    1. Already indicated more than once about a possible negative impact due to not so good economy of middle east countries on account of fall in crude oil price.

      Delete
  13. Your views on SRF ltd. With current state of biz

    ReplyDelete
  14. Is Orbit Export advisable at current level near to its 52 weak low ?

    ReplyDelete
  15. hello vp u said ur avoiding recommending stocks here [in public forum,] are u recommending else where
    thanq

    ReplyDelete
  16. Sir pls share your view on polyplex result

    ReplyDelete
    Replies
    1. Result is improving .One should track the trend of international product price ,being a cyclical industry.

      Delete
  17. Seeing you views on hotel leela for long term

    ReplyDelete
  18. Sir you posted this question is the article of "The Essentials Of Corporate Law" but you didn't answer and this is the question Sir everywhere i am seeing its written that Subex reports fivefold rise in profit at Rs 58.7 crore for the financial year ending March 31, 2016 but for March 2016 its showing a loss of Rs.208 crore and for the full year around RS.131 loss so i am not getting how come a profit of Rs.58.7 crore can you please explain to me sir.
    Please answer this may be its a silly question but i am a beginner in stock market

    ReplyDelete
    Replies
    1. Not sure where you checked the result. I am seeing a profit of Rs.58.72 Cr .

      Delete
    2. Hi Rosh,

      you have seen the standalone result for q4, which included some exceptional items.. Please look at consolidated result.

      Thanks,
      Prakash K

      Delete
  19. Sire, what are your view on NCL after recent result?

    ReplyDelete
  20. Sir I read that sebi is going to stop trading of some 4200 companies is it true? If it is correct it will adversely affect small investors.

    ReplyDelete
    Replies
    1. Read the same correctly

      http://www.thehindu.com/business/Industry/sebi-to-crack-whip-on-4200-firms-whose-shares-are-not-traded/article8646459.ece

      Delete
  21. VP Sir, Your views on Treehouse. It is 90% down from its year high.

    ReplyDelete
    Replies
    1. Its profit in this FY also came down to Rs.6 Cr from Rs,60 Cr of last year.

      Delete
  22. Replies
    1. Working performance not improves as expected earlier.

      Delete
  23. Sir, Are you no more positive on the future of Treehouse as earlier?

    ReplyDelete
  24. Sir , please share your views on recent results of gokaldas exports, thank you.

    ReplyDelete
  25. Hai sir,

    ur view on krebs bio after results?

    ReplyDelete
    Replies
    1. No relevance for result before a company starts its operations.

      Delete
  26. HI VP,

    What are your views on Reliance defence as a long term investment

    ReplyDelete
  27. VP Sir, I stuck in Sankhya infortech and SKM.. Can you share your suggestions on these two companies .. both are in loss only ... Will SKM results waek for next quarter ?.. People are creating panic on SKM message board in money control and tellin you are going to give buy call at 43 .. Is it correct ?.. Please comment mmb and correct the board ..
    Thanks
    Reddy

    ReplyDelete
    Replies
    1. As of now not tracking Sankhya Infotech

      My buy or sell depends more on business improvement.I may not buy a stock @ Rs.10 and may buy the same stock @ Rs.200 , if business fundamentals support that valuation.

      Delete
  28. Sir, Do you follow a company called Gajra Beval Gea??

    ReplyDelete
  29. Sir what is ur view on ajanta soya

    ReplyDelete
    Replies
    1. Result showing improvement , but one should not forget that- out of Rs.4 Cr profit company shown in last quarter more than half is due to other income which may not repeat in each quarter.

      Delete
  30. Sir, pls share your view on Kaveri seeds.

    ReplyDelete
    Replies
    1. As of now not tracking seed sector.

      Delete
  31. Please give your view on Avanti feeds

    ReplyDelete
    Replies
    1. Adjusted to stock split , Avanti given 35 times return from suggested level. Neutral at CMP.

      Delete
  32. Dear Sir why alps industries delisting the shares from BSE..... kindly share your view

    ReplyDelete
    Replies
    1. Not only Alps , even excellent companies like Vesuvius India to delist from BSE. For small companies , it may for saving listing fee etc but in other case they may be not interested to spend too much time for compliance and related matters.

      Delete
  33. Sir throw some light on satin ..hold or book profit

    ReplyDelete
    Replies
    1. This stock suggested around Rs.90 level,booking partial profit and hold remaining at free of cost is one strategy suitable for average risk takers in case of sharply moved stocks.

      Delete
  34. sir any help for those who were not able to sell skm egg at the time of your sell call?

    ReplyDelete
    Replies
    1. Could not understand what help you are seeking.

      Delete
  35. Pl share your valuable views on Yuken , Aegis logistics & Flex Foods

    ReplyDelete
    Replies
    1. Yuken is a good company but very sensitive to Industry performance.

      Adjusted to stock split Aegis already turned as a 10 bagger from suggested level, neutral at CMP.

      Not tracking any cos from Flex group.

      Delete
  36. sir in moneycontrol you have messaged about amulya leasing (apl apollo pipes), what is your view can the same be held for another 12 months .

    as per the sources the turnover for q1 should be above 75 crore with NP of more than 4 crores ..

    kindly post your humble for the same

    ReplyDelete

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