Upbeat music plays throughout.
On-screen text: Lou Mercer, CMT. Regional Investment Strategist
Narrator: So, you got a "hot" stock tip from a coworker, and they sound convincing—what should you do next? The short answer is, do your homework. As astute as your coworker may be, it's important to conduct due diligence on any investment before you put your hard-earned money at risk.
Due diligence, or DD, is all about research—making sure that you understand how a company operates so you can decide whether it's a good investment.
On-screen text: Due diligence. 1. Earnings. 2. Capital structure. 3. Management. 4. Expectations.
Narrator: There are many aspects to due diligence. One part could include fundamental analysis because it delves into a company's ability to make money. At its core, it's the process of analyzing a company's financial statements, and studying other trends and data. That can help you determine whether a stock is fairly valued, undervalued, or overvalued by the market. Fundamental analysis is a large discipline as well, but you don't have to do it all by yourself. You can determine how much you're going to do and what you want to leave to the experts. There are many parts to due diligence, and in this video, we'll discuss four core ones: earnings, capital structure, management, and expectations.
On-screen text: Securities and Exchange Commission. SEC.
Animation: Text is replaced by a sample 10-Q and then a sample 10-K report.
Narrator: To get started, you need to know where to get the right information. Publicly traded companies are required by the Securities Exchange Commission, or SEC, to report financial information to the public in quarterly reports called 10-Qs and annual reports known as 10-Ks. Despite the name, it's not a race but instead a document filled with hundreds of pages of detailed financial information that can feel like a marathon to read. But there are tools to help analyze them if you know where to begin.
Some of the most important financial information for a business shows up in what is known as an income statement. There, you can see how much money, or revenue, is left over after accounting for a company's expenses like paying employees and utility bills. The end amount is known as net income, profit, or earnings, and is a crucial part of understanding a company's value. This is because the stock market is a place where people come to buy and sell the future earnings of a company.
Animation: A sample illustration of a bar graph showing rising revenues and earnings for each quarter over two years. Revenues and earnings are generally rising.
Narrator: A common rule of thumb is that earnings and revenues should be growing—quarter over quarter and year over year.
But there's more you can do with that information, like compare how fast earnings are growing or determine how successful a company is at making a profit. But that would mean a lot of number crunching.
Animation: Four cards appear with different financial ratios. Net profit margin is net income over revenue. Debt to equity is total debt over total shareholders' equity. Price to earnings is market share price over earnings per share. Return on equity is net income over shareholders' equity.
Narrator: The crunching happens by taking data from these statements to calculate financial ratios. These ratios are standardized measurements that can help you analyze how well a company has performed, and what its future might look like.
Thankfully, the work has been done for you and you can get many of these tools and ratios for free in a more palatable way from most brokerages, like on the Research tab on schwab.com.
Animation: An equation is illustrated using a pile of cash labeled net income over a cash register labeled company's revenue. The peers and ratios comparison tool from Schwab.com replaces the ratio. It's set to overview. The net profit margin ratios for a company are highlighted. The "i" icon is selected and a graph of the net profit margin ratios for the company and some of its competitors appears.
Narrator: One example of a ratio is net profit margin, which compares a company's revenue, or the total sales before expenses, to net income—the money it has left over after all the expenses are accounted for. Net profit margin is represented as a percentage, and a company with high margins is usually able to manage its expenses. This could mean it's good at turning a profit.
Profit margins, like other ratios, are great for determining if the company's growing compared to previous quarters and years. They're also good for comparing the company to its peers. Many investors identify top-tier companies by comparing ratios within an industry group.
Animation: The price-to-earnings ratio is illustrated with a stock certificate with a price tag over by a pile of cash labeled earnings per share. The price tag on the certificate changes to $20 and the pile of cash is changed to $1. The peers and ratios comparison appears again, it's still set to overview. The price/earnings line is highlighted.
Narrator: You can use the price-to-earnings ratio to see how much you're paying for a company's earnings and whether the stock is over or undervalued. It compares the price of a share of a company's stock to the company's earnings per share. If a stock is trading at $20 and its earnings per share are $1, then the stock has a P/E of 20. Some investors like to focus on companies with a lower ratio, believing it's a better value.
On-screen text: Due diligence. 1. Earnings. 2. Capital structure.
Narrator: Of course, there's other ways to examine revenue and earnings, but another core area of due diligence is a company's capital structure. It deals with how the business is funded.
Funding is done in a few ways, including selling equity by issuing stock shares or borrowing money in the form of things like bonds, mortgages, and other debt. If a company borrows money or incurs debt to make new products or otherwise expand, it can affect earnings. Debts have to be repaid, so they're essentially a claim on a company's future earnings.
A company with a good capital structure generally keeps its debt and other liabilities in check, while growing equity by retaining earning that can be reinvested into the company.
Animation: The peers and ratios comparison reappears on screen. It's now set to the Fundamentals tab. The long-term debt to equity line is highlighted.
Narrator: The debt-to-equity ratio is a good way to analyze how burdened a company might be by debt. A high ratio that is also higher than the company's peers could be a sign that the company has too much debt, which could be a drag on future earnings.
However, debt levels vary from industry to industry, so peer comparisons are an important part of this analysis.
On-screen text: Due diligence. 1. Earnings. 2. Capital structure. 3. Management.
Narrator: I've talked about analyzing the books, but what about the people keeping the books? Management effectiveness analysis focuses on the ability of the management team to run the company, and it's one of a few soft data points that can be helpful when researching an investment.
Animation: The return on equity ratio is illustrated with a pile of cash labeled company's net income over shareholder's equity. The peers and ratios comparison reappears on screen. It's still set to the fundamentals tab. The return on equity line is highlighted.
Narrator: Successful management can seem abstract, but there's actually another ratio that can help grade how well management does at turning shareholder money into profits. It's called the return-on-equity ratio, and in this case, the higher the ratio, the better. It's calculated by dividing the company's net income by the average shareholder's equity. If a company has a higher number than its peers, investors might perceive that the managers are good at making money.
Animation: The peers and ratios comparison reappears on screen but is expanded to show the other ratings section. Analysts' ratings are highlighted in this area.
Narrator: It's not all about numbers, though. You can also find commentary directly from a company's management team on the company's investor relations website, in the 10-Qs and 10-Ks, and through analyst reports. Those statements can provide insights into what's on the minds of the people in charge, such as product promotions, growth expectations, or even potential dividends.
Animation: A sample 10-K report is on screen. The section titled macroeconomic conditions and related financial risks is highlighted. The page scrolls down to another section title business operations risks.
Narrator: Companies are also required to disclose any present risks they face, which may be an important factor in your investment decision. Risks can include lawsuits that could affect future earnings, or other trouble, like concerns that the company will struggle to market to certain customers.
That's a good reminder about the importance of diversifying the types of stocks you invest in. Investing in companies from several sectors and industry groups that don't usually rise or fall at the same time can help manage risk.
On-screen text: Due diligence. 1. Earnings. 2. Capital structure. 3. Management. 4. Expectations.
Narrator: While earnings growth, capital structure, and management are all important parts of conducting due diligence, much of what's being analyzed is in the past. Investors are most often concerned with the future prospects of a company. This is where the expertise of Wall Street analysts is helpful.
Animation: Three sample documents appear with different forward earnings estimates for three different companies.
Narrator: Banks and research firms around the world pay analysts to study many public companies. They publish frequent reports about their views, including what're known as forward earnings estimates that forecast what they think each company will earn for the upcoming quarter or year. They're educated guesses, but heavily researched ones that analysts make using their professional projections and models. Larger companies tend to attract more analysts, and the reports can be found through most brokerages, including Schwab.
Animation: The research tab on Schwab.com for a stock appears on screen. The screen scrolls down to the expected earnings section. Upcoming earnings and historical earnings are highlighted. Graphs for each estimate appear on screen with summaries and information related to earnings.
Narrator: Analyst estimates tend to be pretty big news when companies report earnings every three months. A company beating or falling short of estimates often result in big jumps or drops in the stock price.
Animation: A document titled analyst estimate appears. The earnings estimate is adjusted from $0.25 to $0.26 and then $0.27. A second company appears. Its estimate is reduced from $0.32 to $0.31 and then $0.30.
Narrator: However, outside of earnings announcements, positive adjustments to an analyst's estimates could be an indication the company may be doing better than expected. Negative estimate adjustments could be a bad sign for the company.
Animation: A bar graph titled cash flow growth appears on screen. The X axis is in years going out to 10. Each bar is made up of stacks of cash representing and estimate cash flow. The top portion of each stack of cash changes to red and a warning sign is placed over each bar. The red sections go away and the bars or stacks of cash shrink.
Narrator: Analysts estimates for the future growth of earnings can help investors calculate the intrinsic value, or fair market value, of a company. Anyone can calculate intrinsic value, but it's complicated. One method requires you to calculate earnings estimates for a company over a period of, say, five or 10 years, then discount those estimates based on how likely it is to happen.
Not only is the discounted future cash flows model complex, but it requires a few educated assumptions, so having analysts to rely on can be a big relief. However, if you are relying on someone else, even an analyst, make sure you understand their assumptions because they may have a different economic outlook, investing time frame, or bias, on the industry than you.
While a hot stock tip is exciting, without doing some due diligence, you could get burned. When you know what you're looking for and where to find it, it's a lot less overwhelming. Remember, the goal of due diligence isn't to make sure you know everything about a company. Instead, it's to help you evaluate the pros and cons so you can decide whether it belongs in your portfolio.
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