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Sunday, July 17, 2011

The Unintelligent Investor's Definition of the Week: Due Diligence

Due Diligence

Oxford definition: Reasonable steps taken by a person to avoid committing a tort or offenceA comprehensive appraisal of a business undertaken by a prospective buyer, especially its assets and liabilities and evaluate its commercial potential.

Unintelligent Investor’s explanation

I haven’t used a made-up-on-the-spot analogy for some time so here is one lol. When you buy an apple, your due diligence will be you looking at its skin and pressing on it to see if it might still be fresh. Or you want to buy a bunch of grapes it might be a good idea to pick one and try it to see if it is sweet lol.

When you perform due diligence on an investment, lets say a share, you look at its financial statements, the recommendations, the board of directors, look at the market depth, volume traded, last price, price of the share in the last x years, etc.

We investigate or do an audit of our potential investment. It is a very important step essential in almost any purchase of assets. It refers to a reasonable care we should take before entering an agreement. What is “reasonable” might be different to different people tho.

I am no accountant so analysing financial statements is not one of my best skills but I approach must companies with scepticism. I think being sceptical is an important part of due diligence. Some information we get from companies are skewed. So it is up to us to be sceptical and try and tease out what is actually going on.