I am a firm believer and ardent supporter of conducting comprehensive research and due diligence on any company (stock) you might consider investing in. However, I have also experienced the reality that far too many investors make their decisions based on opinions, emotions or vague ideas about a company, instead of on comprehensive knowledge and understanding of the business they are considering. Consequently, far too many investors expose themselves to being prone to making significant investment mistakes because they simply do not have the knowledge to keep them from allowing their emotions to rule. In other words, volatile stock price movements can cause them to buy when they should sell – or sell when they should buy.
In contrast, those prudent investors that conduct the requisite research and due diligence are empowered to make rational and sound investing decisions. Furthermore, understanding the business behind the stock also empowers investors to make intelligent and reasoned forecasts of what the business can generate on their behalf in the future. Not the stock price, but the business. In simple terms, these more prudent investors know what their businesses are truly worth. Therefore, they are unlikely to sell when the market is pricing their business lower than it should be, and conversely, unlikely to buy when – and if – the market is pricing their desired company too richly.
Moreover, another issue that I have often come across is the idea that people really don’t know how to comprehensively research a stock. Consequently, they often are deluded by simple statistical references such as P/E ratios or dividend yields without a solid understanding of how those statistics apply to the actual company in question. It’s important that investors recognize that valuation levels, i.e. multiples of earnings, cash flows, etc. are relative. In other words, a company can be trading at, for example, a P/E ratio of 20 and can mathematically be cheaper than a company trading at a P/E ratio of 15. Ultimately, fair valuation is functionally related to the level of future cash flows (earnings) that each respective company can potentially generate. Earnings and/or cash flow growth rates are the keys to understanding fair valuation levels.
Comprehensive Research and Due Diligence: Here’s How to Do It
With all the above said, I was inspired to produce this article because of the excellent research produced by my friend Adam (Dividend Sensei) on the big-box home improvement chains Home Depot (HD) and Lowe’s (LOW). People ask me all the time to explain what comprehensive research and due diligence is. The article found here recently published by Dividend Sensei is a classic example of how research and due diligence should be done. The article provides great insight into the underlying businesses, past, present and future of both Lowe’s and Home Depot.