You can’t avoid it - ‘due diligence’ is a term you’ll hear in reference to every investing avenue, type, and asset class. No matter where you’re putting your money, it’s the single most important thing to learn when beginning your investing journey. It’s what will allow you to make trades and investments with confidence and neutrality, using data-driven insights as opposed to ‘hunches’, emotion, or dubious recommendations.
But you’ve probably heard this a hundred times. The question is, when you’re looking at stocks and shares to invest in, where do you actually start?
Starting your due diligence
In terms of top-level assessment of stocks, start with the company itself. Go to their website, read their PR, and download their Annual Report. You can then turn to news outlets and independent research providers like Morningstar. Be on alert for bias when using the former, and for confirmation bias in yourself (looking for news sources that confirm what you want to believe).
The biggest mistake many new investors make is to stop at this top-level, which is a little better than a speculative analysis.
Next steps for due diligence
There are many ways to analyse companies and their share prices - too many to list within this article. Each investor will also develop their own research methodologies as they become more seasoned. As you progress in your ability, you’ll find trustworthy sources and research methods, and notice patterns in your profits, indicating where you made good calls, and where you interpreted data in an effective way.
For now, let’s start with fundamental analysis - a commonly used form of analysis with a simple but comprehensive framework. Essentially, it can be broken down into story and numbers.
Referred to as a company’s ‘story’ or perhaps more commonly as ‘qualitative analysis’, this aspect provides a deeper insight into the financial stability of the company. It takes into account things that can’t be quantified or put into numbers, for example: what they do, how disruptive they are, what their leadership looks like, what their economic moat might be, and what the future could hold for them based on global market trends and megatrends.
The ‘pro’ of this method of analysis is that you’ll be able to gain unique insight based on your understanding of markets and trends. If you’re able to spot them, you’ll have an edge that other investors may have failed to find.
The numbers part of the analysis looks at everything that can be quantified - a quantitative analysis. Insights at this stage will be drawn from the company’s annual report, cash flow, debt, earnings, and profit.
Specifically, you’ll need to analyse the following:
Earnings Per Share (EPS): company net profit ÷ number of common shares outstanding.
This calculation tells you how much the company has earned you as a shareholder. A higher usually EPS indicates a better return on your investment in the share.
Net Income: $7.6B
Preferred dividends: $0
Weighted common shares: 3.98B
Basic EPS: $7.6/3.98 = $1.91
Return on Equity (ROE): net income ÷ average shareholder equity.
Shareholder equity is equal to company assets minus company debt. ROE is therefore the return on net assets. An ROE near the long-term average of the S&P 500 (14%) is a good ROE ratio. Anything under 10% is generally considered a bad ROE.
Price to Earnings (P/E) ratio: current stock price ÷ earnings per share.
To determine the P/E value, simply divide the current stock price by the earnings per share (EPS).This calculation shows what the market is willing to pay for a stock based on past earnings, and helps you to determine whether a share price is over or under-valued.
A high P/E ratio shows that investors are willing to pay over the odds because they anticipate growth in the future.
A low P/E ratio indicates a stock's price is low compared to earnings and the company may be losing money.
There isn’t a firm rule for a ‘good’ P/E ratio. To discern whether a company’s P/E ratio is good or bad, you’ll need to look at how it compares to the industry average.
Take Uber, a global behemoth with a P/E ratio of -20 at last look. A negative P/E ratio means the company has negative earnings or is losing money (sometimes a negative P/E isn’t even reported and marked as “N/A”).
Uber, like many other tech companies, is playing the long game – if you believe it can continue to raise capital and fund its operations on the path to profitability, then it could be a good long-term investment. But generally, low or negative P/E ratios are cause for a closer look.
Dividend Yield: cash dividends per share ÷ market value per share.
Growth companies like Afterpay, Netflix and Zoom don’t pay a dividend, instead opting to reinvest any profits back into the company. Investors in companies that do not pay a dividend are usually seeking one thing: long-term capital growth.
But for ‘blue chip’ stocks like Commonwealth Bank, BHP or Telstra, investment decisions are usually made based on dividend yield as well as potential growth.
When assessing dividend yield of a stock, check to see how consistent dividend payments have been historically. A high dividend yield isn’t necessarily a no-brainer. Could it be because the stock price is declining? Often, the best balance between dividend payment and stable company fundamentals is 4-6%. Dividends of 10%+ are possible, but ask why they’re so high, and does the company have the financial strength to maintain this increase?
These calculations can sound a little dry and intimidating if you’re not used to them. But although the written words can sound confusing, the calculations themselves are straightforward.
This post provides a rundown of the broadest set of analytical tools you can use when learning to conduct due diligence. But you might also choose to explore technical analysis, which is more commonly used when looking at short-term investment decisions, including ’active trading’ strategies such as day trading, position trading, and swing trading.
Naturally, a combination of multiple strategies can be advantageous. How you choose to blend them will depend on your timeframes and long term goals.