Foreplay & Due Diligence
A Guide to Understanding Stock Picking & Two Things You Should Never Start Without
I’ve recently become obsessed with Outlander - a Netflix series about a WW2 nurse, named Claire, who travels back in time and falls in love with an 18th century Scotsman, Jamie Fraser. I’ve never really been into shows like The Bachelor or Reality TV, but I have always loved historical fiction. John Snow, I’ll never forget you.
However, one thing I have noticed in the show is the lack of foreplay in any sex seen. And while Outlander is not the only show/movie guilty of this, it’s been quite top of mind to me given the scenes are more frequent than GOT season 1 (iykyk). In fact, yesterday I was watching an episode where the main characters were talking with their friends on a boat deck and then 20 seconds later they are below deck rocking each others’ boats. While I know it’s done this way for dramatic effect, it sets a false precedent for what the act should be like.
I am not trying to turn into a full fledged sex column, so I won’t be elaborating on the appropriate approach to Foreplay - there is Cosmo for that. But I will tell you it’s quite necessary and I wish the entertainment industry did a better job portraying it. This also leads me to today’s topic - due diligence. Because you shouldn’t have sex without foreplay and you certainly shouldn’t invest without due diligence.
What is Due Diligence?
Due diligence is the investigation of a potential investment (such as a stock) to confirm the facts. These facts can include financial records, past company performance, financials and anything else deemed material.
For the purpose of this article, I will walk you through conducting due diligence on a single name stock.
What do Due Diligence and Foreplay have in common?
They should come first - “Fore” comes from the Latin word “igitur” which means “before.” Foreplay quite literally means before sex. You shouldn’t be trying to do the deed then ask, “hey, can I kiss you now?” Due Diligence should also be coming before any investment you make, especially if you are investing in a single name stock or alternative vehicle. It involves in depth analysis of companies and comparing them to other similar businesses to assess which is the best investment to make.
Practice makes perfect - Conducting due diligence for your first time is going to be similar to sex for your first time. It’s a bit overwhelming, takes time to master, and won’t be perfected overnight. While I am going to walk you through the steps for due diligence, I am also sure you’ve read hundreds of articles on sexuality but there is simply something unbeatable to practice.
They are Personal - What you enjoy and do with your partner is deeply personal and there is no simple right or wrong. Well, maybe Jamie Fraser was wrong in that last boat scene. Due Diligence is also going to be personal. I am going to give you a bunch of tools you can use, but you certainly don’t need to use all and may prefer some analysis techniques over others. In fact, that’s what most investors do. Some analyze stocks based on their value, some based on their price to earnings, some based on their leadership, and some based on larger market driven theories. Some will guess and pretend they are an expert. You need to figure out which approaches work best and make the most sense to you (if you actually want to get into the business of stock picking).
How Do I Conduct Due Diligence?
Before we dive in and you start investing in single name stocks, please read this article to make sure you are ready to do so. If you aren’t in step 5, maybe consider holding off before investing your life savings into TESLA.
Market Cap - Market Cap is the total dollar market value of a company's outstanding shares of stock. Aka, it is how much the company is currently worth. Before you make a stock investment, you want to understand if the company is large-cap ($10 billion or more), mid-cap ($2 billion to $10 billion), and small-cap ($300 million to $2 billion).
How to Calculate it: A company with 10 million shares selling for $100 each would have a market cap of $1 billion. You can also google a stock and look for “Mkt cap” per the below.
Why it’s Important: Understanding a company’s market cap is a basic determinant of risk. If a company is large cap, they have likely been around for longer, reward their investors and are typically safer investments. Think: JNJ (Johnson & Johnson) and AAPL (Apple). Mid-cap companies are typically in a growth stage, carry slightly higher risk, and also can have higher short term return. Think: AEO (American Eagle Outfitters). Small-cap companies are typically newer, more volatile and the most risky given their size. On the other hand, they can have greater growth opportunities. Think: GME (Gamestop).
Financials - After you assess the size of a company, now you want to dig into the financials which are the numbers related to the company. There are countless financials you can assess but to get started, check out the below.
P/E ratio(Price-to-earnings): This is used to assess the attractiveness of an investment based on the price of a company's shares relative to its earnings. In other words, it measures how a company's stock price is valued by comparing the current stock price to its earnings-per-share (EPS).
How to calculate it: If a Pelaton’s stock price is $10, and its EPS is $0.50, Peloton has a P/E of 20 =($10/0.50). If the EPS rose to $0.75 with the stock remaining at $10, the P/E would become more attractive because the price is undervalued (the stock price stayed the same although the earnings increased).
Things to be mindful of: When you are comparing companies by their multiples, it is important to compare similar businesses. You can’t look at the P/E ratio of a small cap clothing company and a large cap food manufacturer and make a sound decision. Consider comparing similar businesses and multiple financials before acting on the numbers.
P/B ratio (Price Earnings to Growth): This compares a company’s market cap to its book value. It is how we understand equity value (what the market thinks the company is worth) to its book value (what we know it to be worth).
How to calculate it: Let’s say Peloton has $100 million in assets and $50 million in liabilities. The book value of that company would be calculated simply as $50 million ($100M - $50M). If there are 10 million shares outstanding, each share would represent $2 of book value ($10m/$50m). If the share price is $5, then the P/B ratio would be 2.5x (5 / 2). This essentially means the market price is valued at 2.5 times its book value.
Things to be mindful of: High-growth companies will often show P/B ratios > 1.0, while companies in distress may show ratios < 1.0.
Compare - When reviewing fundamentals, revenue, stock prices, and beyond, it is important to compare across similar industries and sectors. As stated above in my comment on P/E, you can’t compare apples to oranges. I certainly would not compare John Snow to Tyler Cameron.
Things to Be Mindful Of
You Don’t Need to Actively Invest to Be Successful - If you are planning to work with a robo advisor or private wealth advisor, you may not need to conduct in depth due diligence or analysis. That’s what they do on your behalf. In addition, the majority of these individuals and services aren’t even in the business of stock picking but rather invest you in diversified, low cost index funds and ETFs. They conduct due diligence on these positions but don’t necessarily go line by line with their portfolio companies.
You Still Need to Diversify - Now that you’ve mastered due diligence, please do not go find “the best stock in the world” and pump your life savings into it. Due Diligence is investigative but not always 100% accurate. In fact, the market itself can be extremely irrational, so don’t assume that sound due diligence will always equal sound return. I mean, I’m sure you’ve done your fair share of excellent foreplay but things still didn’t turn out as planned. Be prepared for uncertainty, hold diversified positions, and treat speculative positions as supplementary to your overall portfolio (especially if you are just getting started).
Due Diligence isn’t just for stocks - Due Diligence is important for any investment you make whether it is buying a house, buying into your friend’s Kombucha business or purchasing your first nice piece of art. It protects you from fraud, protects the security of your money, and helps prevent bad business decisions. While I could not elaborate on how to do this for each, I will cover due diligence for angel investing and home ownership in the next few weeks!
Thank you for reading!! If there is a topic you want to discuss, please DM me on Instagram at @notyourbfsinvestmentadvice or email me at firstname.lastname@example.org. I also am building a company called Tardi - a financial wellness and investment platform. If you’re interested in joining the beta, sign up here: https://www.tardiapp.com/
See you next week lover!
Disclaimer: All investment strategies and investments involve risk of loss. Nothing contained in this website should be construed as investment advice. Any reference to an investment's past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.