Investing in stocks is a popular way to grow your savings, but it comes with unfamiliar terms. Learn what DD means and how to follow due diligence when investing in stocks.
When talking about stocks, DD stands for due diligence. This refers to taking the time to research your investment before buying a stock. It lets you confirm that buying the stock fits your overall investment strategy. With due diligence, you aim to reduce your risk with your stock investment.
Learn more about due diligence, including how to follow it and protect your investments.
What Does DD Stand For In Stocks? And How To Follow Due Diligence
When you first start investing in stocks, you may face a lot of unfamiliar terms, including DD. DD stands for due diligence, and it is an important principle that all investors should follow. Take a closer look at what DD means, what it involves, and how to follow it.
Stock DD Meaning
As mentioned, DD is an abbreviation for due diligence. A simple definition of due diligence is investigating your potential investment before buying it. But it can go into much more detail than this.
With due diligence, you look at a long list of factors regarding the company in question. These include:
- Financial performance
- Market sentiment
- And more
While DD is important for stocks, it is also smart to practice due diligence for any investment. No matter the type of investment you plan on making, from real estate to bonds to ETFs to cryptocurrency, due diligence will help you make an informed decision.
As a retail investor, you want to engage in due diligence. But you can also expect any fund manager, broker-dealer, or equity research analyst to do so.
History of the Term
The phrase due diligence became popular in the 1930s. It specifically followed the Securities Act of 1933. With this law, brokers and securities dealers became accountable for disclosing information regarding the instruments they sold. If they didn't disclose this information to potential investors, it was a criminal offense.
Why Due Diligence Matters
The biggest reason due diligence matters is to protect your investments. By performing DD, you will become aware of potential warning signs that you shouldn't invest in a given stock. You will also have a much better idea of its volatility and the risks associated with your investment. Remember that DD is important for any investment you make, not just stocks.
You can think of due diligence for stocks similar to doing your research before making a major purchase. Or think of it as serving the same purpose as a home inspection or a test drive on a used car. It simply lets you confirm that you are making the right decision based on the strengths and weaknesses of the stock in question.
How To Do Due Diligence On A Stock
Due diligence is well-established in stock investing, along with best practices. While there are some variations of doing due diligence, any financial expert is likely to suggest some of the same core practices. At a minimum, consider the following factors. Remember that all of these refer to the company behind the stock. So, if you are thinking about investing in Apple's stock, you should research Apple.
Start With the Basics
Before you get too far along with your due diligence, make sure you understand the basics. Most importantly, you should understand the business. What do they sell? Their goals? What sets them apart from the competition?
Market capitalization (market cap) is the company's total value. To calculate it, multiply the number of shares by the share price. This figure will tell you the size of the company and its reach.
Larger companies are less volatile and more likely to deliver consistent revenue, but the potential gains aren't usually as large. By contrast, smaller companies are more volatile. This makes them riskier but also increases the potential gains.
Valuation looks at whether a company is fairly valued, overvalued, or undervalued. This is based on how its financial performance compares to market value.
You can use several ratios to determine valuation, including:
- Price to book
- Price to earnings
- Price to earnings growth
- Price to sales
Pay close attention to variations between the valuation of your chosen company and its competitors. You may even want to research more about the competitor at this point. You should still finish your due diligence for the current stock, but feel free to add the competitor to your to-check list.
Stock Price History
You can get an idea of recent trends by looking at the price history of the stock. Look at price movement, both long-term and short-term. Remember that most people investing in more volatile stocks will only hold the stocks for the short term. This can increase the risk factors depending on the situation.
Stock Options And Dilution
Stock options are worth looking into because of the potential for dilution. This is when companies give employees stock options as part of their compensation plan. Sometimes, price movements lead to employees exercising stock options. That could affect the stock price or dilute shares. You can find this information on the 10-K and 10-Q reports.
Look at the competitors of your chosen stock and how each performs. Specifically, you want to look for signs that your chosen stock will be overtaken by competitors and industry trends as a whole.
Revenue And Profit Margins
A company's revenue is the amount of money that the company earns. The profit margin is the percent of the revenue that is profit. You should look at both current figures and recent trends for these data points.
Ideally, you want to look at data for the last two years. This information will help you get a feel for the company's consistency. It can also help you determine if the company is growing, staying the same, or shrinking.
This part of your due diligence involves looking at the balance sheet to see the liabilities and assets of the company. You should also look at revenue sources, net income, and cash flow.
Pay extra attention to the company's long-term debt. Remember that more debt isn't always a warning sign. It will depend on the business model of the company. It's smart to check the debt-to-equity ratio. This will let you see the amount of positive equity of the company. The best way to evaluate this figure is to compare it with that of competitors.
Management And Ownership
This part of due diligence is when you look at the team behind the company. Does the executive or management team have experience? You also want to look at how much stock the management owns. Generally, it is a good sign when management owns a fair amount of stock. If management had a recent sell-off of stock, don't invest.
Expectations And Analyst Estimates
One of the most important parts of DD is to look at what analysts and experts say. Look at their projections and the reasons for those predictions. Remember to look at predictions and expectations from multiple experts, as this will give you an overarching view. Looking at analysis from several experts also reduces the risk that you will miss something. After all, if one analyst failed to consider a certain point or weakness, another likely did.
Weaknesses And Risks
Before any investment, make sure to consider the risks associated with it. Examples include potential lawsuits and competitors. You can also look at the company size, as smaller companies have a higher risk. You should also explore the financial situation of the company.
Don't forget to look at the industry as a whole and the company itself. For example, maybe regulations are likely to change soon, or the industry is becoming less popular due to environmental concerns. This is the time to think of the worst-case scenario. Make sure that you are willing to put up with the risks before investing.
One risk for any company would be changing regulations or industry trends. As such, this is also a good time to confirm that the company in question can adapt to changes. Maybe they have a history of adapting in the past, or maybe their leadership team does. Or perhaps they have multiple revenue streams to provide backup income while adapting.
When To Perform Due Diligence
Based on the above checklist, it's clear that due diligence is a fairly involved process. As such, it should be one of your final steps before investing. Simply put, you want to know what stocks fit your needs before you move on to due diligence. You should ideally only perform due diligence on stocks you are almost ready to buy, as opposed to those you are only vaguely considering. Think of it as the final step before you buy a stock.
DD or due diligence is thoroughly researching a company before you buy its stock. It reduces your risk by helping you make an informed decision. Due diligence should be your final step before buying a stock, and you should apply similar principles to any other type of investment you make.
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Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.