As an investor, you need to understand that picking stocks is different from due diligence in the share market. In stock picking, the focus is on investing in undervalued (or fair-value) stocks. Due diligence is the next step in the journey, where you learn how to avoid loss in the share market. After this process, you make the final buying decision. You must be wondering – how to do due diligence in the share market. Today, we discuss the parameters you must evaluate for due diligence.
Understanding due diligence
As an investor, when you want to buy shares of company ABC Ltd, you research company ABC by looking at its financial statements, listening to con calls, and reading news articles about the company’s business and its industry. This research is part of your due diligence, which helps you decide whether investing in the company is a good idea.
Parameters to evaluate for due diligence
Below are some crucial parameters that you need to consider in the due diligence process:
Company balance sheet: The first and most essential part is the balance sheet evaluation. You need to check the company’s financial statements and look for red flags. For example, you need to see if the net profits reported come from operations or some other sources (such as asset sales). The other parameter to check is cash flows, working capital, debt, etc. Once you see a green signal related to these parameters, you move to the next stage.
Company’s moat: Even the best company can collapse if it does not have a strong moat. We all know what happened with Kodak – one of the largest players in the camera market a decade ago. Today, they don’t stand anywhere on the table. Look for companies with a competitive edge, and that can sustain any disruption.
Governance standards: Governance, in simple language, means whether the company’s management is acting in the larger interest of the shareholders. If management’s interests are unaligned with that of shareholders, it is a governance issue and may hurt investors in the future. When there is a misalignment, the promoters may borrow too much to avoid diluting equity and expose their investors to substantial financial risk. Companies with governance issues are a strict no for investors.
ROE growth: One of the best indicators that show that the company is on the right path is Return of Equity (ROE) growth. It shows what the company is earning for its investors. The rule of thumb is – if the ROE is higher than the cost of equity, the company is creating value for its investors. ROE reflects two things, business profitability and efficiency of asset utilization. In the due diligence process, you look for companies that show rising ROE.
Compare with a competitor: Now that you have some confidence in the company, you need to move on to the next stage – see how it competes with others. Compare the margins with all competitors. By looking at the major competitors in each line of the company’s business, you can determine how big the end markets are for its products. If you are a Shark Tank viewer, you know that sharks want to find out a lot about the company’s competitors in which they are interested in investing. Finding competitor details is not a tough job – you will find them on most stock research sites.
Stock fits in your long-term financial goals: Everything may be right about a company, but the last question you should ask is if it fits into your long-term financial goals. Every investor should invest according to their risk profile and have an asset allocation. If a stock is disturbing your asset allocation or increasing your portfolio risk, you should take it off your list during the due diligence process.
Research is of utmost importance in equity investment – it is one way to avoid losses in the market. However, based on the above discussion, it is evident that the research is tough and not everyone’s cup of tea.
If you are sure that you cannot carry out the due diligence process yourself, you need to look for the best stock market advisor in India. Alternatively, you can use technology to help you in the end-to-end investing process. The choice is yours, which path you want to take – the important thing is that you carry out the process and do not leave your investment to faith.
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