Double Down. Dungeons & Dragons. Dunkin’ Donuts. What does “DD” actually mean?
In the investing world, DD is an abbreviation for “due diligence” — the investigation of a potential investment.
You may have seen the term on Reddit’s Wall Street Bets, or elsewhere in the financial media.
It is indeed important to do your DD. Let’s break it down.
What does DD mean?
DD stands for “due diligence”.
Due diligence is an investigation of a potential investment opportunity. DD in stocks refers to taking a closer look at a company’s fundamentals, financial performance, valuation, market sentiment, and other factors.
You can think of due diligence like getting a home inspection. You wouldn’t buy a house without hiring a home inspector to check for problems.
Likewise, you shouldn’t buy a stock without first checking out the company’s strengths and weaknesses.
DD is important for all types of stocks, from blue-chip companies to penny stocks. In fact, it’s important for any investment.
The elements of stock market due diligence (DD)
To conduct due diligence on a new stock you’re considering, these are the key components to pay attention to:
- Company market capitalization (the total value of the company)
- Revenue and profit margin trends
- Competitors & industries
- Valuation
- Management and ownership
- Financial health
- Stock price history
- Stock options & dilution
- Expectations & analyst estimates
- Risks & weaknesses
How to conduct due diligence for a stock
Before investing in stocks, you should always take a close look at the company or companies you are considering investing in. Here’s a due diligence checklist for stocks.
1. Check the company’s market capitalization
Market capitalization, or market cap, refers to the total value of the company. It’s calculated by multiplying the share price by the number of shares. You can also view a company’s market cap through your stock broker, or on a platform like Yahoo Finance.
Market cap matters because:
- It shows you how big the company is
- It shows you how big the company’s reach is (Amazon has a massive global reach; a regional hotel chain has limited reach)
- Larger companies tend to be less volatile and have more consistent revenue
- Smaller companies tend to be more volatile, but may have more upside potential (like junior mining stocks)
2. Examine revenue and profit margin trends
Revenue refers to how much money a company is bringing in, while profit margin shows the percentage of that money that is actual profit.
It’s wise to look at current revenue/profit, as well as historical trends for the last few years. Much of this information can be found in company earnings reports.
Revenue/margin trends are important because:
- They show how consistent the company has been
- They show whether the company is growing, shrinking, or staying the same
- They show whether a company is profitable or not
- They are used to calculate key metrics like price-to-sales ratio (P/S), and price-to-earnings (P/E). These terms are discussed more in the valuation section below.
3. Explore competitors & industries
What competitors does the company have? What industry or industries does it operate in? Is it performing strongly against competitors, or losing market share to them? How do the company’s margins and valuation compare to competitors?
Examining a company’s competition is important because:
- Even a great company can be overtaken by competitors
- Comparing competitors can tell you a lot about how fairly a given company is valued
- Comparing revenue and profit margins can show the financial performance of a company
- It could lead you to other investment opportunities
4. Check valuation multiples
Valuation refers to how fairly a company is valued, based on its financial performance compared to its market value.
Valuation is important because it tells investors whether a company is undervalued, overvalued, or fairly valued. It also makes it simpler to compare similar companies and their valuations.
There are a few different ways to look at valuation. These are the common methods and their acronyms:
Price to earnings ratio (P/E): The P/E ratio is calculated by dividing the current share price by the earnings per share. It’s useful for comparing profitable companies.
Price to sales ratio (P/S): The P/S ratio is calculated by dividing the current share price by the company’s total sales per share (usually prior 12 month sales, or future 12 month sales projections). It focuses on revenue, rather than profit.
Price to earnings growth ratio (PEG): The PEG ratio is calculated by dividing the P/E ratio by the company’s earnings growth rate over a period of time. It’s helpful for comparing high-growth companies, which often have high P/E ratios.
Price to book ratio (P/B): The P/B ratio is calculated by dividing the company’s market cap to its book value (book value is the net assets of the company, taken from the balance sheet). It’s often used to value insurance, financial, and real estate companies.
5. Examine ownership and management structure
Is the company’s management team proficient? What kind of experience level do company executives have? Read the company’s annual report to dig in.
Looking at ownership structure — and insider stock ownership — is also helpful. If executives at the company own a lot of company stock, that could be a good sign. If they’re aggressively selling their holdings, that could be a red flag.
6. Examine financial health
Taking a close look at the company’s balance sheet is important. This will show the assets and liabilities that the company has.
Beyond the balance sheet, you’ll also want to look at cash flow, net income, and different revenue sources. Does the company have stable revenue streams? Is net income positive or negative? What trends can you identify?
Financial statements will be available on the company’s website, usually in an “investor relations” section.
7. Consider the stock price history
Has the stock price been volatile, or has it shown smooth and steady growth? Is it on an upward trend, downward trend, or moving sideways?
Stock price is just one small element to look at, however. Take it with a grain of salt.
8. Examine stock options & dilution
Companies issue stock options to employees as a part of compensation packages. If stock prices move substantially, many stock options might be exercised — potentially diluting the shares, or affecting the stock price.
Quarterly SEC filings from the company (10-K and 10-Q) will shine some light on outstanding stock options and other related information.
9. Consider market & analyst expectations
What are analysts expecting for the company’s future? What are the revenue and earnings per share projections? What are the analyst price targets for the stock price? What is the mood in the financial media, and even on social media?
Taking a broad look at what other experts think about the company can be helpful.
10. Explore risks & weaknesses
What are the risks associated with the company, industry, or the stock itself? Are there competitors that could overtake the company? Are there outstanding lawsuits or legal actions to consider?
A company’s financial situation is the biggest place to look for risks. Size can make a difference, too — stock in small-cap companies may have more volatility, for example.
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