Are you sick of getting Fooled into terrible stocks? Stock DD or Due Diligence is arguably the most important step in investing. We all know the golden rule: You shouldn’t invest in something you don’t understand. Yet when it comes to shares many new investors find themselves stuck on how to actually analyze a stock. As a result, they YOLO their money into a meme stock from r/ASX_Bets, or even worse they get Fooled into terrible stock DD’s. So here’s actually how to analyze stocks in 10 simple steps.
What does “Stock DD” mean? Due Diligence is defined as an investigation of a potential investment (such as a stock) or product to confirm all facts.Stock DD, Definition from Investopedia
Why is Stock DD Important?
For all investors, the research and due diligence stage is the most important step. Arguably this holds even more truth for new and beginning investors. Money is made on the buy. We are surrounded by media which talks about the latest hype stock, for new investors it can be easy to be drawn to the promises and stories behind the latest craze whether it be weed stocks, lithium, or uranium. We get told constantly that these stocks are going to the moon! We’re surrounded by pressure from Reddit, Fools, HotCopper, and general media.
As a result, it can be difficult for a new investor to understand the concept of buying and holding good quality businesses. Instead, we can get caught up in the hype and FOMO. As a result, beginners can find themselves caught up in the latest Pump-and-Dump of terrible micro-cap companies. Leaving them scared from the world of investing. This is where a proper stock DD checklist comes in.
Investopedia defines a pump and dump as: “a manipulative scheme that attempts to boost the price of a stock or security through fake recommendations”. In these instances, the involved parties will hold securities in the targeted company and will use many platforms especially online to draw hype and attention to the stock to attract more investors in-turn raising its price. The parties will then sell their shares at a profit. Small Cap companies are often targeted as their share price is easier to manipulate.
One of the best ways to avoid a pump-and-dump is to use the common sense of a proper stock DD strategy, this is even recommended by SEC.
We can see the ‘Anatomy’ of a Pump and Dump in The Hype Cycle:
We read about the Hype Cycle by the great team over at The Hype Train who have allowed us to share it today. Although it is designed regarding technology it is fitting to the phases of a pump-and dump stock.
Taken directly from Gartner these stages are:
- Innovation Trigger: A potential technology breakthrough kicks things off. Early proof-of-concept stories and media interest trigger significant publicity. Often no usable products exist and commercial viability is unproven.
- Peak of Inflated Expectations: Early publicity produces a number of success stories — often accompanied by scores of failures. Some companies take action; many do not.
- Trough of Disillusionment: Interest wanes as experiments and implementations fail to deliver. Investments continue only if the surviving providers improve their products to the satisfaction of early adopters.
- Slope of Enlightenment: More instances of how the technology can benefit the enterprise start to crystallize and become more widely understood. Second- and third-generation products appear from technology providers. More enterprises fund pilots; conservative companies remain cautious. Or further hype surrounding the company.
- Plateau of Productivity: Criteria for assessing provider viability are more clearly defined. The technology’s broad market applicability and relevance are clearly paying off, at least for now.
Real Examples of the Pump-and-Dump Hype Cycle:
Our Ultimate Stock DD Checklist
It’s important to note this is a strategy for doing Due-Diligence and research around finding a quality company to invest in and not getting stuck on the latest speccy hype, for tips valuing a stock using a full fundamental analysis technique check out this article here.
How to Analyse Stocks:
- Step One: Identify the Stock
- Step Two: Understand the company
- Step Three: What is their Market Capitalization?
- Step Four: Screening Software for Stock Analysis
- Step Five: Financials How to Analyse Stocks
- Step Six: Cap Raise! Dilution Probabilities
- Step Seven: Buy Sell ratios and Volume
- Step Eight: Prospects
- Step Nine: Competition
- Step Ten: Insider Ownership and Management
Step One: Identify the Stock
The first step to a stock DD is obviously finding a stock to DD. There are many ways to go about doing this. Maybe you got a recommendation from a friend, maybe you read some of our articles, or maybe you got Fooled into “ThIs StOcK iS ThE NeXt AftErPaY”. The important thing to note here is the intent of the source that is mentioning the stock. Do they have a vested interest? What is their motive behind mentioning the stock?
For these reasons, it may be a good idea to identify your own stock. Have a think about companies that you interact with and see if they are publicly traded. Or browse through the ASX listings. Although these strategies are likely not ideal you can be sure there’s no ulterior motive.
Step Two: Understand the Company
This is an extension of the phrase “don’t invest in something you don’t understand”. The same goes for individual stocks, it’s probably not a good idea to invest in a company if you don’t even know what they do.
“You have to learn how to value businesses and know the ones that are within your circle of competence and the ones that are outside”Warren Buffet
So, Step Two is to understand what the company is, what they do, and how they make money. Here’s how:
1. Search the Businesses ‘About Us’ Section
Pretty much all ASX listed companies will have a webpage with an ‘about us’ section browsing this and their website can be a good starting point to understanding their business, and a good start to a stock DD.
2. Use Market Index and Read the Company Profile
Market Index is a great tool for all ASX listed stocks, it also features a ‘Company Overview’ section for every stock which gives a quick synopsis about the business and what they do. Market index is a great free software for stock analysis.
How Much Do I Need To know?
The more the better! There’s the old saying that you should be able to pitch the business to Warren Buffet in a 30-second elevator ride. Or the classic line by Peter Lynch “Never invest in an idea you can’t illustrate with a crayon.” As a starting point you should be able to answer at least these four questions;
- What sector is the company in?
- What does the company do?
- How does the company make money?
- How long has the company been around?
Step Three: What is their Market Capitalization?
A company’s market cap or market Capitalization is how much the stock market determines a company is worth. it is calculated by the total market value of all outstanding shares. Companies are often categories in terms of market cap as Large, mid, and small-cap. There is no set definition on these terms, although Westpac defines it as;
Large cap companies
large cap companies generally have a minimum market capitalization of $10 billion or more. The top 50 companies according to float-adjusted market capitalization, can be considered Large Cap.
Large cap companies are more likely to show consistent returns over time rather than short-term gains. Their prices are likely to be less volatile. Large cap companies also tend to make regular dividend payments.
Mid cap stocks
Mid-cap stocks generally have a market cap ranging from $2 billion to $10 billion. In terms of market capitalization, they may be considered stocks ranking from 51-100.
These stocks tend to be established companies in the process of expanding in industries that are expected to experience rapid growth. Because they don’t tend to be as established as large cap companies, they generally involve a higher level of risk.
Small cap stocks
Small cap companies are generally classified as having a market cap between $300 million and $2 billion and are often categorized as growth stocks. A growth stock is considered to have the potential for above-average growth but also a higher degree of risk.
Below this, stocks may also be considered micro-cap. Again, there is no set definition on these terms.
Why is this Important?
Each category can be a good investment strategy it’s just important to note that each group has different companies at varying levels of maturity. You shouldn’t buy a micro-cap and be surprised if it gets delisted instead of paying dividends. Likewise, you probably shouldn’t buy a Large Cap Bluechip and hope their share price goes to the moon overnight. Each has its pros and cons.
Step Four: Screening Software for Stock Analysis
There are a lot of websites and tools available to screen the stocks in a quick fundamental analysis. There are many free and paid services but here’s what I recommend and use for my stock DD:
Trading View has a lot of information on stocks from all over the world. Including all ASX-listed companies. Using this tool we can search for companies using a bunch of metrics including performance, market cap, dividends, financials, the list goes on. Using the stock screening tool we can filter out a lot of stocks that don’t meet our requirements, which is very helpful to stock DD multiple businesses. We can also view a company’s profile which brings up a lot of basic information to help us analyze a stock.
Market Index is a good starting point to find out information on a company. They have a lot of general information about the stock market and list profiles for all ASX companies. Using this we can see past price performance, company information, announcements, dividends, ownership and insider information, and fundamental factors.
Personally, I prefer the other two methods but yahoo finance also has a lot of information that can help us in our stock DD. Notably, they have an excellent financial section for each stock which highlights the main points from their financial statements making it easy to compare a company’s progress over time and assess their financial situation.
Simply Wall St takes a unique approach and presents its information in a graphic representation. Simply wall St charges a subscription fee, however, they allow you to analyze five stocks a month for free. They are a user-friendly method of finding out some quality stock DD information.
What are we looking for?
After picking one (or more) of these tools that works well for you, we are going to perform basic fundamental analysis on the stock. Again this is just for beginners we’re not going to be coming up with an intrinsic value, we’re simply going to look for red flags that might deter us. The important thing is don’t bias your favorite stock, instead be brutally honest about its fundamentals.
Here’s what we will examine:
Earnings Per Share (EPS): EPS or Earnings Per Share is the portion of the profit earned for every ordinary share on issue. It is calculated by taking the net profit and dividing it by the number of ordinary shares, it is measured in cents per share. look at the trend of EPS over time and ensure that it is increasing rather than remaining stagnant or falling.
Price to Earnings Ratio (PE): EPS is also used to calculate the Price to Earnings Ratio or PE, this will then account for the overall share price allowing comparison between companies. The PE ratio can be interpreted as the amount you pay for $1 in company profits. For example, if the PE is 10, it means investors are willing to pay $10 for every $1 in company profits.
A company with a high PE could be seen as overvalued or that investors are expecting large growth in the future, they can also be seen as riskier. In comparison, a company with a low PE could be seen as undervalued or may have poor investor sentiment. A company with no profits will not have a PE. The average PE for the ASX all ordinaries is around 15-20. PE is the basic ratio for a stock DD.
- PE 0/NA: The company has no earnings
- PE 1-14: The company is undervalues/has low investor sentiment regarding growth
- PE 15-20: Average
- PE 20+: The company is overvalued/has high investor sentiment regarding growth
Book Value: The book value is the net assets of a business divided by the number of shares on issue. As such it can be thought of if the company was liquidated today it would be the amount investors receive for each share. The net assets are given as total assets minus total liabilities. Again, this is another one of our favorite metrics for a quality stock DD.
Debt: This is an extension on book value. A company should have more assets than liabilities to avoid bankruptcy. We like companies with low-to-no debt. If a company has debt, ensure it is well covered by assets and earnings
Return on Equity (ROE): Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets. ROE measures how many dollars of profit are generated for each dollar of shareholder’s equity. ROE is a metric of how well the company utilizes its equity to generate profits.
Higher ROE = The better the company are at making money from equity and vice versa.
We like companies with consistently higher ROE over 10. A low ROE means low growth potential.
Past Performance: We all know ‘past performance is not indicative of future returns’ but it can pay to have a quick look at the stock chart and see what the price has been doing. Have they been trading sideways for three years? Are they stuck in a never-ending trading halt? Is it a falling knife? Is it volatile or steady and how does this suit you?
Step Five: Financials How to Analyse Stocks
This is largely an extension to step four since most share ratios are an extension of a companies financials. However, we are a huge advocate of basic share accounting. So, find the companies latest Yearly or Half-Yearly report. This can be done through Market Index or the ASX Website.
Once you find the latest report scroll down to the financial section where we will find three key documents: Income Statement, Balance Sheet, and Cash flow statement. These are core to a good stock DD. Here’s how to read them:
This statement contains the company’s revenues, costs, gross profit, selling, and administrative costs, other expenses, and net profit which is the difference between revenues and expenses.
The balance sheet displays all the company’s assets and the company’s liabilities. In effect, it is based around the simple formula Assets=Liabilities+Equity and Networth=Assets-liabilities.
Cash Flow Statement
The Statement of Cash Flows details the movements of money throughout the income year. It can also show us the cash and cash equivalents a company holds, which can be easily converted into assets. It should be analyzed in conjunction with the previous statements. A Cash Flow Statement is broken down into three major components: Operating Activities, Investing Activities, and Financing Activities.
Step Six: Cap Raise! Dilution Probabilities
As a new investor there can be nothing more frustrating than seeing your share getting hit with Cap Raise after Cap Raise and seeing your shares diluted to nothing. This is a common reality for many small-micro cap stocks. There’s nothing wrong with capital raises it’s just important to expect them for certain stocks.
One easy sign that a company is constantly raising capital is through looking at its share price and number of shares on issue. This is no guarantee but a very very low share price and a large number of shares on issue may be a sign they have had a lot of capital raisings. Look through the company’s announcements using Market Index or ASX and see if they have a large history of capital raisings.
We can also use the financials we read before to try and predict if the company is adequately capitalized.
Again, I want to stress that a capital raise is not necessarily a red flag. Last year we saw some of the biggest companies’ cap raise. But getting constantly hit by raisings can lead to dilution and is frustrating if you’re not expecting it. So do your stock DD first.
Step Seven: Buy Sell Ratios and Volume
We’ve got to remember the stock market is exactly that, a market for stocks! So, it’s a good step to see if there are a healthy number of buyers and sellers and decent trading volumes. The best way to do this is using your trading platforms since they display real-time data of the market. If you’re looking for a quality broker here’s who we recommend to help with your stock DD.
Here’s what it looks like:
In this case, we see a good number of buyers and sellers trading with good volume. The number of buyers is greater. This is a good example of a healthy market for these shares. In a not-so-healthy market, we would have low trading volumes and poor sentiment. In this case, it may be difficult to sell your shares at the right time, so a good stock DD is important.
Step Eight: Prospects
When examining a company for your stock DD we should consider its macro and microeconomic factors. Notably regulation and future industry outlook and disruption. There is no right or wrong answer to this, but it just helps in gaining an understanding of the business. So be honest with yourself!
Regulation is around predicting the risks or benefits that could be afforded to a company based on government or industry regulation. Regulatory factors could be positive and negative. As these are often speculation it can be hard to imagine how or if they would impact a business. It is more appropriate to draw conclusions once the regulations are announced or apparent rather than trying to guess ahead of time.
Future Industry Outlook and Disruption
This factor is very similar to regulation but also accounts for non-government factors. For example, it may be about the development of the internet and the impact this has had on e-commerce and standard brick-and-mortar stores. The disruption of Blockbuster by online streaming platforms. Or the way Uber has revolutionized ridesharing and disrupted the taxi industry.
If you’re holding a stock for the long term, does it stand the possibility of regulation or disruption? How would this affect your holdings? Have you considered this in your stock DD?
Step Nine: Competition
Competition is an extension of Industry Outlook and Disruption, but now we will compare the stock to its direct competitors to see how they compare. To do this we are going to go back to step four and compare the company’s fundamentals against its competitors. If the competitors are better then why not consider investing in them instead?
Does the company have any competitive advantage? Do they have an economic moat?
“In business, I look for economic castles protected by unbreachable moats“. Warren Buffett
The five types of economic moats;
- Low-cost production; Companies that can keep their prices low can maintain market share and discourage competition.
- High switching costs; Customers and suppliers might be less likely to change companies or providers if the move will incur monetary costs, time delays, or extra effort. e.g. banks and power providers.
- Network effects; network effect happens when the “value of a good or service grows” as it’s used by existing and new customers e.g. Amazon is an excellent example.
- Intangible assets; Brand identity, patents, and government licenses are examples of intangible assets. e.g. think Nike or Coca-Cola as an excellent brand and think of the government regulation surrounding gamble and the moat this creates for gambling companies.
- Efficient scale. Companies that have a natural monopoly – or operate in markets or industries where there are few rivals.
Step Ten: Insider Ownership and Management
Management can be broken down into two sections: Insider Ownership and Management Experience.
Insider Ownership: We generally like companies with large insider ownership. This is big for small-cap companies. Skin in the game helps ensure the management’s motives are in line with ours. So we use Simple wall St which shows Insider Ownership and Trading very clearly. We like small-cap stocks with ~30% insider ownership and a history of owners buying on market. For large-cap companies’ insider ownership will be lower, 3-5% would be decent in this case.
Is management buying or selling large amounts of shares? Sudden large selling by management for no apparent reason may hint that management believes the company is overvalued or peaked at that point in time.
Management Experience: Consider educational and professional backgrounds. One of the most important factors is their experience in the industry. Their reputation is also key. What goals has the management set out for the company? Have the leaders had successful projects in the past or did they fail?
It is also important to have a look at the compensation of the management. Good leaders are priceless, however, if management is being paid exorbitant fees for poor performance then maybe they’re taking advantage of the company. This is why we are a big fan of performance-based compensation.
Bonus Step: Speccies are Sentiment and Hype
After going through every step and doing a thorough DD, it’s important to mention that the market is unpredictable. Even with the most advanced analyses, speccies are just sentiment and hype. By every stretch of fundamental analysis, they are terrible companies, that doesn’t mean you can’t make money off them. Just be ready for the pump-and-dump!
“Speccies are just sentiment and hype”
Keep in mind what sort of investor you want to be, create your own goals and figure out what works for you.
Share Purchase Due Diligence Checklist: Prophet’s Take
This is just a starting point for beginners, it’s not going to make you rich overnight but it will serve as a method of benchmarking your future investments. From here you can invest with confidence and understand what it is you’re buying into rather than just going along with the hype of the latest pump-and-dump or taking a stock tip from your broke mate.
From here you can begin to grow your own investment strategy and make wise investment decisions. If we’ve helped even one investor from getting Fooled “WiTh ThE NeXt AfTerPay” or stung by their mate’s trash speccy stock then this article has been a success.
We release full DD’s using this method weekly on our website under the titles “Should I buy” give them a read here.
What Are We Currently Buying?
In the past few weeks here’s some exciting companies we jumped in on: