Module for Investors
Advanced Fundamental Analysis - Valuation
5. Beyond numbers - doing your due diligence
Doing a thorough financial analysis and valuation exercise is important when you’re looking at investing in a company for the long term. However, numbers are not the only thing that you should focus on. Due diligence should also form an important part of your investment decision. Due diligence is nothing but an investigation that you carry out to get to know a company better.
Take a look at investment banks, for instance. Whenever they’re looking to buy a stake in a company or acquire a business, they conduct a thorough financial analysis combined with an extensive due diligence exercise. Sometimes, they go even a step further and hire dedicated professional consulting firms to do the legal and accounting diligence for them. This way, they get to know everything there is to know about a company, making it easier for them to evaluate the entity.
Similarly, as an investor, it is necessary that you also look into these aspects. Since you would be investing a sizable portion of your hard-earned money, you should also conduct a similar exercise to ensure that you invest in a good, stable company. So, in this chapter, we’ll be delving into the world of due diligence to take a look at some of the pointers that you, as an investor, should focus on getting to know before investing. Let’s first start off with legal due diligence.
Legal due diligence
Legal due diligence involves conducting a thorough examination into the legal aspects of a company. This is done with a view to ensure that the entity is in no way contravening the applicable laws, rules, and regulations. A company that flouts the laws, whether advertently or inadvertently, opens itself up to potentially damaging lawsuits that can erode its wealth. So, let’s take a look at some of the key legal issues that you should examine before investing in a company.
Laws that govern the industry and the company
Examining and reading through the various key laws that govern the industry in which the company operates in would be a good place to start your due diligence exercise. This could give you a lot of information about the industry as a whole and how it is regulated. It would also make it easier for you to check if the company has been following the rules laid out.
Also, you could check out if there have been any recent changes in the policies and laws affecting the industry. And look for how those changes have impacted the company. For instance, the recent corporate tax cut from the base rate of 30% to around 22% is a fine example of a policy change that has had a very positive impact on companies in general.
Memorandum and articles of association
The memorandum of association and the articles of association are very important documents that clearly list out the things a company is authorised to do. They generally vary from one company to another. The memorandum of association (MOA) lays out the objectives of a company, whereas the articles of association (AOA) specify the way certain tasks need to be carried out in the company.
These documents contain the specific set of objectives for which the company has been incorporated. Any objective that a company carries out or hopes to carry out in the future should have been authorised by the MOA and the AOA. For instance, if the main objective of a company according to its MOA is to manufacture two-wheelers and the company carries out an activity that involves the manufacture of mobile phones, it would be in direct contravention of its own set of rules. Therefore, this is something that you should keenly examine while conducting a legal due diligence exercise.
Decisions taken by the Board of Directors and at the Annual General Meetings
Any major business decision that a company undertakes must legally be passed by the board of directors in their meeting, or by the shareholders in the annual general meeting. This is why it is essential to review the minutes of both the board of directors’ meetings and the annual general meetings of a company.
This way, you can keep yourself aware of the business decisions that a company has undertaken or is planning to undertake in the near future. The simplest way to get this information is by visiting the stock exchange’s website, since all listed companies are required by law to file the outcomes of all their meetings with them.
Existing and potential future lawsuits
Lawsuits can cause significant distress to the finances and the resources of a company. And so, you need to verify whether the company you’re planning to invest in is embroiled in any legal disputes. If the company is currently being sued in a court of law, it would be a good idea to keep yourself informed of the lawsuit’s proceedings.
This way, you can, to a certain extent, predict whether the ruling would go in favour of the company or against it. A company that has too many lawsuits filed against it is generally viewed as a bad investment choice. Also, you need to keep an eye out for any potential future lawsuits that can be filed against the company if it has been flouting any norms or rules.
Most businesses, especially manufacturing companies, are required to adhere to strict health, environmental, and safety requirements. Any lapses in this regard can expose them to crippling lawsuits, which can then erode the wealth of the company.
Outstanding tax payments and other legal obligations
Taxation is another area that you would need to focus on when conducting a due diligence exercise. A company could run into unexpected tax problems due to changes in the tax structure or rules. Or alternatively, it could also have certain outstanding tax payments that need to be paid off to the authorities. Delays in payment of outstanding tax liabilities might open the company up to penalties and additional interest on the tax, which can strain the finances.
In some cases, the income tax authorities might also come up with additional demands to pay tax for previous accounting years. This usually occurs if the authorities disallow certain expenses claimed by the company, thus increasing its tax liability. In such a case, the company usually doesn’t give into these demands and tries to contest it in a court of law. Focusing on this area would bring to light instances such as these, which can impact the financial situation of the company significantly.
Corporate governance policies
A detailed examination of the corporate governance policies can sometimes bring certain glaring issues to your notice. You’ll recall that a company’s annual report has a section on corporate governance. This is the best possible source of information with regard to the corporate governance policies.
Corporate governance is quite an intricate concept. It has several sections and sub-sections. Going through them with a fine-toothed comb can sometimes bring out certain issues or lapses that can quickly become costly if they’re not fixed in the early stages.
If a company doesn’t meet the spending requirements for corporate social responsibility (CSR) activities in a year, it is generally a sign of a lapse in corporate governance. Or, if it doesn’t disclose the details of related party transactions in accordance with the rules laid out, it is again a corporate governance issue that has to be addressed appropriately. Keep an eye out for things like this.
Key changes in the management
The changes in the key managerial personnel of a company play a significant role when it comes to highlighting the issues faced by a company. When conducting legal due diligence, it is very important to direct your focus towards the changes in the management and the reasons for such changes. You need to check for resignations of directors and other managerial personnel and the reason behind their move.
Sometimes, such resignations or removal of directors can be a sign of failure of corporate governance. For instance, in the case of Yes Bank Limited, in the year 2018 and 2019, several key managerial personnel who were associated with the company for years exited the entity in quick succession. This was an early indication of serious lapses and failure in corporate governance, the effect of which showed up quite late, when the value of the shares of the company eroded by over 80%.
Accounting due diligence
Well, now that legal due diligence is covered, let’s move on to another segment of the due diligence exercise - accounting due diligence. When we talk about accounting due diligence, we aren’t essentially focusing on the numbers. Instead, the exercise requires you to look into the accounting policies that a company employs.
The accounting policies of a company tell you a lot about how the company recognises revenue and expenses, and whether it is in tune with the generally accepted accounting standards. Here’s a brief look at some key points that you should focus on when conducting accounting due diligence.
- The accounting policies that the company employs, with extra focus on the areas where the law allows differing accounting policies to be used
- The assets owned and leased by the company
- The cost that the company might have to incur to replace any key equipment that has reached the end of its useful life
- The accounting practices followed by the company in connection with the recognition of revenue, inventory management and valuation, and valuation and categorisation of accounts receivables
- The existing debt liabilities and other contingent provisions
- The audit report of the company
- The stock ownership including the shareholding pattern of the company
That’s about it for this chapter. In the next one, we will be taking a look at some of the factors that influence and affect valuation. And once we’re done with that, we’ll focus on how you can build a valuation model of your own with the Discounted Cash Flow (DCF) method. It is going to be an exciting ride, so stay tuned!
A quick recap
- As an investor, it is essential that you conduct a due diligence exercise before deciding to invest in any company.
- Legal due diligence involves conducting a thorough examination into the legal aspects of a company.
- As a part of legal due diligence, you need to examine the laws that govern the industry and the company.
- You also need to look at the MOA and the AOA, and the decisions taken by the Board of Directors and at the Annual General Meetings.
- Existing and potential lawsuits, outstanding tax payments and other legal obligations, corporate governance policies and key changes in the management are also examined as a part of legal due diligence.
- Accounting due diligence requires you to look into the accounting policies that a company employs.
- The accounting policies of a company tell you a lot about how the company recognises revenue and expenses, and whether it is in tune with the generally accepted accounting standards.
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