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Most of the due diligence of a company begin with the Ministry of Corporate Affairs. On the website of the Ministry of Corporate Affairs, the master data about a company is made publicly available. Further, with payment of a small fee, all documents filed with the Registrar of Companies is made available to anyone. This information from the MCA website is generally verified first. The information and documents gathered in this step include:
The date of Incorporation
The paid up capital
The date of the last annual general meeting
The date of the last balance sheet
Status of the company
The directors of the company
The date of appointment of directors
In addition to the above, the financial information of the company and other filings with the MCA pertaining to various aspects of the company can be downloaded and reviewed. The review of MCA documents of the company would provide a good overview of the company to the person performing the due diligence.
It is imperative to review the articles of association of a company during the due diligence process to establish the different classes of equity shares and their voting rights. The articles of association of a company can restrict/limit the transfer of shares of a company. Therefore, the articles of association should be studied judiciously to ascertain the procedure for transfer of shares.
Under Companies Act, 2013, a private limited company is required to maintain various statutory registers relating to the share transfer, share allotment, board meetings, board of directors, etc., Therefore, the statutory registers of a company must be reviewed to obtain and validate the information pertaining to the directorship and the shareholding.
Companies are required to maintain the book of accounts along with detailed transaction information by the Companies Act, 2013. The detailed financial transaction information must be audited and verified against the financial statements that are prepared by the company. Some of the matters relevant during the business financial due diligence process are:
The taxation aspects of a company must be thoroughly checked during the due diligence process. This helps to ensure that there are no unforeseen/unexpected tax liabilities created on the company in a future date. The following aspects relating to the taxation aspect of a company must be checked:
A complete legal audit of the company has to be performed by a legal practitioner to establish if there are any pending/incomplete legal actions, suits by or against the company and the liability in each. Further, the following aspects must be checked during the legal due diligence:
It is important to acquire a thorough understanding of the business operations, business model and operational information during the process. The review of the operational aspects must be all-encompassing including the site visits and employee interviews. Following are the aspects that must be covered and documented in the operational aspects review:
Determine just how big the company is. The company’s market capitalization says a lot about how volatile the stock is likely to be, how broad the ownership might be and the potential size of the company's end markets. For example, large cap and mega cap companies tend to have more stable revenue streams and a large more diverse investor base, both of which generally equate to less volatility. Mid cap and small cap companies, meanwhile, may only serve single areas of the market, and may have more fluctuations in their stock price and earnings. When you start to examine revenue and profit figures, the market cap will give you some perspective.
Conversely, the largest, most expensive real estate in any market is generally less liquid than more average-priced properties. You should also confirm one other vital fact on this first check: What stock exchange do the shares trade on? Are they based in the United States (such as the New York Stock Exchange, Nasdaq, or over the counter)? Or, are they American depositary receipts (ADRs) with another listing on a foreign exchange? ADRs will typically have the letters "ADR" written somewhere in the reported title of the share listing. This information along with market cap should help answer basic questions like whether you can own the shares in your current investment accounts.
When beginning to look at the numbers, it may be best to start with the revenue and profit margin (RPM) trends. Understanding a company's gross revenue, profit margins and return on equity and whether it is growing or shrinking is essential in any equity or corporate bond investment.
Profit margins should also be reviewed to see if they are generally rising, falling, or remaining the same. Some investors demand that a company's return on equity plus its profit margins be equal to 50 or greater – the higher the better. This information will come into play more during the next step.
Now that you have a feel for how big the company is and how much money it earns, it's time to size up the industries it operates in and who it competes with. Every company is partially defined by its competition. Compare the margins of two or three competitors. Looking at the major competitors in each line of business (if there is more than one) may help you nail down just how big the end markets for products are. Is the company a leader in its industry? Is its industry growing overall, and could
its position in the field change?
Information about competitors can be found in company profiles on most major research sites, usually along with a list of certain metrics filled in for both the company you're researching and its competitors. If you're still uncertain of how the company's business model works, you should look to fill in any gaps here before moving further along. Sometimes just reading about some of the competitors may help to understand what your target company does.
Now it's time to get to the nitty-gritty of price-to-earnings (P/E) ratio, price/earnings to growth (PEGs) ratio and price-to-sales (P/S) ratio and the like, for both the company and its competitors. Note any large discrepancies between competitors for further review. It's not uncommon to become more interested in a competitor during this step, but still look to follow through with the original pick.
P/E ratios can form the initial basis for looking at valuations. While earnings can and will have some volatility (even at the most stable companies), valuations based on trailing earnings or on current estimates are a yardstick that allows instant comparison to broad market multiples or direct competitors. Basic "growth stock" versus "value stock" distinctions can be made here, along with a general sense of how much expectation is built into the company. It's generally a good idea to examine a few years' worth of net earnings figures to make sure most recent number (and the one used to calculate the P/E) is normalized, and not being thrown off by a significant one-time charge or adjustment.
Investors in real estate sometimes examine the cost to replace a building as compared to the value of the entire property. Not to be used in isolation, the P/E should be looked at in conjunction with the price-to-book (P/B) ratio, the enterprise multiple, and the price-to-sales (or revenue) ratio. These multiples highlight the valuation of the company as it relates to its debt, annual revenues, and balance sheet. Because ranges in these values differ from industry to industry, reviewing the same figures for some competitors or peers is a critical step.
Finally, the PEG ratio brings into account the expectations for future earnings growth, and how it compares to the current earnings multiple. In some areas this ratio may be less than one, while in others it may be as much as 10 or higher. Stocks with PEG ratios close to one are considered fairly valued under normal market conditions.
Is the company still run by its founders? Or has management and the board shuffled in a lot of new faces? The age of the company is a big factor here, as younger companies tend to have more of the founding members still around. Look at consolidated bios of top managers to see what kind of broad experiences they have; this information may be found on the company's website or on SEC filings.
Also look to see if founders and managers hold a high proportion of shares, and what amount of the float is held by institutions. Institutional ownership percentages indicate how much analyst coverage the company is getting, as well as factors influencing trade volumes. Consider high personal ownership by top managers as a plus, and low ownership a potential red flag. Shareholders tend to be best served when the people running the company have a vested interest in the performance of the stock.
Many articles could easily be devoted to just the balance sheet, but for our initial due diligence purposes, a cursory exam will do. Look up a consolidated balance sheet to see the overall level of assets and liabilities, paying special attention to cash levels (the ability to pay short-term liabilities) and the amount of long-term debt held by the company. A lot of debt is not necessarily a bad thing, especially depending on the company's business model. But what are agency ratings for its corporate bonds? And does the company generate enough cash to service its debt and pay any dividends? Some companies (and industries as a whole) are very capital intensive, while others require little more than the basics of employees, equipment, and a novel idea to get up and running. Look at the debt-to-equity ratio to see how much positive equity the company has going for it; you can then compare this with the competitors to put the metric into better perspective. In general, the more cash a company generates, the better an investment it's likely to be.
If the "top line" balance sheet figures of total assets, total liabilities and stockholders' equity change substantially from one year to the next, try to determine why. Reading the footnotes that accompany the financial statements and the management's discussion in the quarterly/annual report can shed some light on the situation. The company could be preparing for a new product launch, accumulating retained earnings or simply whittling away at precious capital resources. What you see should start to have some deeper perspective after having reviewed the recent profit trends.
At this point, you'll want to nail down just how long all classes of shares have been trading, and both short-term and long-term price movement. Has the stock price been choppy and volatile, or smooth and steady? What was the price three and six months and one, two, three, five and 10 years ago? Is it rising or falling? Does this history match its profit trends? All this outlines what kind of profit experience the average owner of the stock has seen, which can influence future stock movement. Stocks that are continuously volatile tend to have short-term shareholders, which can add extra risk factors to certain investors.
Next, investors will need to dig into the 10-Q and 10-K reports. Quarterly SEC filings are required to show all outstanding stock options as well as the conversion expectations given a range of future stock prices. Use this to help understand how the share count could change under different price scenarios. Are there any insider lock-up expirations on the horizon? Is it conceivable that the company may complete a secondary offering? While employee stock options are potentially a powerful motivator, watch out for shady practices like re-issuing of underwater options or any formal investigations that have been made into illegal practices like options backdating. With real estate, look to see if there is any inventory that could be brought to market nearby?
This is a sort of a catch-all, and requires some extra digging. Investors should find out what the consensus of Wall Street analysts for earnings growth, revenue and profit estimates are for the next two to three years. For real estate, what is the opinion of professionals regarding future price trends and interest rates? Investors should also research discussions of long-term trends affecting the industry and company-specific details about partnerships, joint ventures, intellectual property, and new products/services. News about a product or service on the horizon may be what initially turned you on to the stock, and now is the time to examine it more fully with the help of everything you've accumulated thus far.
Setting this vital piece aside for the end makes sure that we're always emphasizing the risks inherent with investing. Make sure to understand both industry-wide risks and company-specific ones. Are there outstanding legal or regulatory matters, or just a spotty history with management? Is the company eco-friendly? And, what kind of long-term risks could result from it embracing/not embracing green initiatives? Investors should keep a healthy game of devil's advocate going at all times, picturing worst-case scenarios and their potential outcomes on the stock.
What is the worst case scenario? If a new product fails or a competitor brings a new and better product forward, how would this affect the company? How does an investing plan manage downside risk? For real estate, how would a jump in interest rates affect the ability to carry a mortgage on a property?
Once you've completed these steps, you should be able to wrap your mind around what the company has done so far, and how it might fit into a broad portfolio or investment strategy. Inevitably you'll have specifics that you will want to research further, but following these guidelines should save you from missing something that could be vital to your decision.
Yes, it is appropriate to know the legal compliances made by the Company upto date before entering into Shareholders agreement with the Company.
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