Complete Investor’s Guide for Stock Due Diligence

A common acronym used by investors on forums like Reddit, Wallstreetbets, and on Fintwit is DD stock. But what is the meaning of DD stock, and why is it important?

DD refers to due diligence, and it represents the research and analysis process that an investor needs to conduct before committing to any investment. The acronym DYOR (do your own research) is also used to represent due diligence.

As an investor, you need to research and evaluate every investment opportunity. By doing so you are able to make the right investments and achieve above-average returns. In order to know exactly which stocks are worth investing in, you need to perform your stock DD.  

What is the meaning of DD stock?

DD stock means due diligently researching a stock investment opportunity. Investors will often perform stock DD based on technical analysis, fundamental analysis, or a combination of the two. 

The process also includes an assessment of the risk-reward profile of the stock. In which investors try to estimate the potential upside as well as the possible downside.

How do you evaluate a stock before buying?

Evaluating a stock before buying requires investors to analyze three main aspects:

• Fundamental analysis
• Technical analysis
• Qualitative analysis

Fundamental Analysis

Fundamental analysis is the study of a stock’s performance metrics as well as the external macroeconomic factors. A stock investor using fundamental tools should analyze the business model, the leadership, core competence, and external factors including interest rate, economic conditions, inflation, and so on. The aim of fundamental due diligence is to find the true intrinsic value of the stock.

Technical Analysis

Although technical analysis should not be the sole basis of stock DD, it is still an important aspect investor should consider. Despite some investors thinking that technical analysis does not work, it can still be used in stock DD. Technical analysis argues that the current market price of a stock reflects its value. It states that investors can use technical indicators to study the past performance of the stock to predict its future performance.

It is important to mention that technical analysis often aims to bring short-term profits. Thus, the word historic performance may refer to as near history as the last trading day. Due diligence through technical analysis is the study of trends, charts, price, volume, and volatility changes.

Qualitative Analysis

Both fundamental and technical analysis looks at the quantitative measures of a stock. The research often revolves around the study of the financial statements and the stock price number-crunching.

A qualitative analysis should be an integral part of any due diligence process for appraising potential stock investments.

A few key points of qualitative analysis should include the study of:

• The leadership and top management of the company
• The competitive advantage and competitors of the company
• Research patents, trademarks, and other valuable intangible assets
• Industry and economic impacts on the particular stock

How do investors do due diligence?

Depending on the investor’s investment strategy the due diligence process might be different. However, seasoned investors usually follow a complete stock DD process that includes several factors. Here are some of the most important due diligence steps for stocks:

• Analyze the industry
• Understand the competition
• Historical data
• Assess management quality
• Review the financial statements
• Understand the risks
• Valuation
• Compare with peers
• Outline the risk-reward profile
• Make estimates and forecasts
• Estimate returns

In order to conduct a stock DD that is thorough and can save you time, follow these steps:

Analyze the industry

Perhaps one of the most important parts, before you jump into stock DD stock, is to analyze the industry in which the company operates. You have to make sure that this industry falls upon your circle of competence, and that you have the skills to analyze companies in it. 

Some of the key aspects to understand about any industry start with answering these questions:

• What is the competition like?
• Is the industry growing?
• How does this industry relate to my current investment portfolio?

Competition is one of the key aspects of any industry. Ideally, you would want to look into industries that are not so competitive, because this often will mean that companies will fight fiercely for market share, and it could lead to lower profits or margins.

Another key part of any industry analysis is to determine if the industry is growing. As an investor, you want to make sure you are investing in a growing industry. Declining industries will often signal lower future revenues and profits, and that does not generate great returns.

Knowing how the industry relates to your current investment portfolio is also another important part of it. You want to avoid industries that are directly or indirectly related to the stocks you already have. Otherwise, it might seem that you are trying to diversify, but it is related diversification. Investors often fall upon this trap, and it is a form of diworsification.

Understand the competition

If your initial industry DD was positive, you should try now to understand the competitive landscape of the stock. This focuses not only on its core industry but on other industries. Especially when it comes to large corporations that have several segments, and operate around many industries, it becomes essential to understand the competition they will face.

An important point to address is: Are there any competitors in the industry that have a moat?

An important key factor is to determine if any of the companies in the industry have a moat. If you researching a certain industry filled with competitors with large moats, it might be a better idea to avoid the stock DD process. This is because that company will most likely have a hard time competing directly with well-established businesses with moats.

If there are a lot of different companies with moats, it might be better to find another stock to research. 

Historical data

If both the industry and the competition passed your initial checkpoints it is time to look at historical data. You want to make sure you can get the financials of the company over a large span of years. Part of the financial analysis of the company starts with determining the consistency of its financial results.

You want to find companies that have stable growing revenues and profits. You also want to make sure that the company has not taken too much debt over the last years. It is also important to see how the number of outstanding shares has changed over the years. If there are too many shares being issued every year, that could mean there will be more shares issued, which will dilute existing shareholders. Another important consideration is to understand data anomalies. 

For example, if the company increased its revenues significantly in one year, why did that happen? Determining the reasons behind the numbers is crucial.

You also want to closely look at the stock chart. Try to look for periods of large increases or decreases in price, and try to understand historically why they happened.

Assess management quality

There are several ways to determine management quality and here is how you can do it:

• Check if the company meets management estimates
• Check if the management follows up on their own projections and goals
• Stock-based compensation and salaries should be proportionate to the financial performance

One of the simplest ways to determine the quality of the management is to look at estimates. Oftentimes analysts will estimate the financials for the company, and so will the management. It is a good sign when management estimates are precise, and end up becoming true. This means that the management team behind the company is knowledgeable about the business. 

You also want to make sure that the management team follows on their promises, and goals. The simplest way to understand this is by reading older earnings calls. Usually in earnings calls you will get access to a lot of information, including the management views on the company and industry. If the CEO or the CFO mention they will do something, or share some projection regarding the company, you have to make sure that they execute it. Finding companies where the management is well aligned with the rest of the shareholders is a very important part of stock due diligence.

Lastly, you want to make sure that the stock-based compensation is not above a certain level. Sometimes management is clearly overpaid, either through their salaries or stock-based compensation. Always try to be critical of the compensation received in comparison with the results achieved.

Review the financial statements

Analyzing financial statements should be one of the most lengthy parts of this process. Start with the income statement, and try to determine if revenues and earnings are growing and if margins are stable. You want to make sure that you understand the reasons behind changes in the data. Make sure the interest expense is also at a reasonable level. You want to avoid companies with high debts, and with large interest payments that can eat up all those earnings.

You should also look at the balance sheet to determine how much liquidity the company has, and what kind of assets it owns. Be wary of goodwill, which can lead to goodwill impairment. It is also important to see what kind of debt the company has, and when does it has to repay it.

Finally, you should look at the cash flow statement, this is perhaps the most important of the 3 financial statements. Check if the operating cash flow is positive or negative, and divide the market cap by the operating cash flow. This ratio should be important to understand the company’s ability to generate cash. The most important and often disregarded metric is free cash flow. Check if the company’s CAPEX will increase in the coming years, and once again divide market cap or enterprise value by free cash flow. The lower the number is, the lower the valuation usually the stock is more attractive.

Financial statements and numbers tell a story, and it is your job to understand what that story is all about. So for example, a company that makes plastic parts might see a decrease in earnings in a period of higher oil prices. This will also push margins lower.

Understand the risks

Once you have analyzed carefully, the industry, competition, financials, and historical data you need to determine the risks associated with the stock. Ponder everything that can go wrong with this investment, and what are the chances of some of those risks materializing. 

You want to avoid extremely risky stocks, even if the valuation is very low. You also want to make sure that the risks with this stock, are not related to the risks you already have on other stocks you own. Risk is an important part of determining the valuation of the company and attributing certain multiples at which the stock should trade. 

Valuation

The valuation is the most important part of the DD stock process. If you value stocks accurately, you will always make money in the stock market, although it makes take time until the market price reflects the true valuation of a stock.

A valuation should reflect the amount of money you are willing to pay based on the competition, industry, historical data, and financials of the company. Without completely disregarding the possible risks the stock might face.

Ideally, you want to find stocks that are undervalued, and are trading below the valuation threshold you determined during your stock DD.

Compare with peers

Once you have determined the right valuation for the stock it is now time to compare it with other companies in the same industry. Understand why a competitor might have a higher or lower valuation. 

This could be a good way to compare both companies. You will find that sometimes competitors might have a much higher or lower valuation. Understand the reasons behind it, and determine whether it makes sense for a stock to trade so much higher or lower than a competitor.

Outline the risk-reward profile

Investors also need to compare the risk-reward profile of different stocks. Is it more attractive than another stock you have researched, or is it riskier? The risk-reward profile should help you determine the possible returns of the stock and the possible price decline. Use it to compare stocks you are doing due diligence on.

Make estimates and forecasts

Once you have gathered all of this information it is now time to start doing your own estimates. A great way of doing so is by looking at analyst estimates for the company. If you have the chance to read some analyst reports that could also be a great way to understand the rationale behind those projections. 

You want to make sure that your estimates include different types of scenarios. So for instance, you will have a very positive scenario where revenues and earnings grow higher and a negative scenario. Your goal should be to consider the valuation of the company even in the worst-case scenario. If an investment makes sense even in the worst-case scenario then you will likely make money on it.

Estimate returns 

To conclude, you want to estimate your returns if you invest in the stock. Considering all of those steps in the due diligence process, you want to make sure the estimated returns are worth the investment. Depending on your risk tolerance, risk capacity, and your investor profile some stocks might not be worth considering.

Should you read research reports and news for stock DD?

You should always read the research reports and news about potential stock investments.

It’s always a good idea to keep an eye on the trending news as that affects the stock prices directly. In the long run, a company’s overall performance plays a key role in determining its future.

What is DD stock meaning for trading and investing?

The due diligence for investors is different than for traders. If you are a short-term trader you will be looking at factors like volume, and moving averages. It won’t be necessary to conduct a deep fundamental analysis on a stock before you decide to trade it. Conversely, fundamental long-term investors will focus on researching not only the company but its industry.

Why is stock due diligence important?

Stock DD is absolutely one of the most crucial parts of every investment. You want to make sure you know what you are investing in. Without doing any DD on a stock you may find yourself investing in a stock that might decline and generate losses.

Why DD stock is important for investments?

The most important factor for investors is to find the right stocks to invest in. Due diligence helps them to analyze and research stocks in order to determine if they are investment-worthy. Traders also use due diligence, although their goals are slightly different. Part of their research also touches upon the same key aspects as investment due diligence.

Conclusion

No matter if you want to day trade a stock, or invest in it for the long-term - investors need to be aware of DD stock meaning. Due diligence is required in every investment, in order to avoid making rushed investment decisions that can rapidly turn into mistakes. 

Actively looking for stocks, and performing the required due diligence is the only way investors are able to beat the market. Make sure you research a stock before you invest in it.

Image source: Unsplash