Any newcomer to investing is usually advised to carry out their due diligence beforehand as a way to safeguard their capital. Generally, it involves doing your homework about a fund manager and product in order to verify that the information provided is true and to see if it fits your investment needs.
Due diligence should be the crucial first step of any large financial decisions you make. In fact, a positive correlation has been found between individuals who conduct their due diligence and the performance of their investments.
However, information on what exactly due diligence entails can be scanty, especially if you are not a financial or investments expert. For this reason, today we explore what you should consider when carrying out due diligence for a potential investment.
1. Company valuation
Before buying any stock, you need to understand how much the company is valued at. Examining its price/earnings to growth ratio is a good place to start. You should also look at the net revenues from the previous years. This information will give you a good understanding of the company’s performance and a basis to forecast future performance.
2. Corporate governance
Whenever you are doing your due diligence on a stock, you should be able to answer basic questions about the firm’s ownership and management. Consider its age, the management team, and what their areas of expertise are. Ask about how often changes in top leadership happen, as this could be an indication of stability or lack thereof. Additionally, inquire about how much of the firm’s shares management holds. Low personal ownership could be a warning sign because the decision makers have a low stake in how the stock performs.
3. Revenue/margin trends
An important part of due diligence is the financials of the fund manager or company whose stock you are considering investing in. Start by examining the revenues, profit or loss, and margin trends. This information is usually easily available to investors and it should give you a good idea of whether growth is stable or inconsistent.
4. Associated risks
Every investment comes with some level of risk. The best way to mitigate it is to first understand it. Ask yourself what risks come with investing in or through a given company? Is the firm regulated? Is it facing any outstanding legal matters? Can its management be trusted to govern in a manner that will increase revenues?
These are just some pertinent questions you should ask with regard to risk.
5. Risk management strategy
Because risk is inherent in investments, how a fund manager manages risk should be an important consideration when doing your due diligence. Is there a strategy in place? Based on its previous performance, is it effective? While it is not realistic to expect a detailed rundown of what the firm does to manage risk, you should at least have a general idea of what risk protections you should expect.
Doing your due diligence might be a lot of work and may involve pushing yourself to learn new, sometimes complex concepts. However, it is a necessary precursor of sound investment decisions.